We explore the connection between money, banks, and aggregate credit. We start with a simple real' model without money, where banks make loans repayable in goods and depositors hold claims on the bank payable on demand in goods. Aggregate production may be delayed in the economy. If so, we show that the level of ongoing bank lending, and hence of aggregate future output, can decrease with increases in the real repayment due on deposits: ceteris paribus, the higher the amount due, the more likely there will be insufficient goods, given the delay, to pay depositors, and the more new lending has to be curtailed to make up the shortfall. Thus a temporary delay in production can be exacerbated by banks into a more permanent reduction of total output. A number of inefficiencies including bank failures can result if deposits turn out to be too high. We then introduce money in this model. We show that if demand deposits are repayable in money rather than in goods, banks can be hedged against production delays: under certain circumstances, the price level will rise with delays in production, reducing the real value of the deposits banks have to pay out. But demand deposits payable in money can expose the banks to new risks: the value of money can fluctuate for reasons other than delays in aggregate production. Because deposits are convertible into money on demand, a temporary rise in money demand immediately boosts the interest rate banks have to pay depositors, which in turn boosts the real amounts banks have to repay them. This increase in the real deposit burden can again lead to the curtailment of bank lending and even bank failures. The way to combat these contractionary effects is to infuse more money into the banking system. Our analysis thus makes transparent how changes in the supply of money can work through banks to affect real economic activity, without invoking sticky prices, reserve requirements, or deposit insurance. It also suggests how bank failures could lead to a fall in prices and a contagion of bank failures, as described by Friedman and Schwartz (1963).
Download Info
To download:
If you experience problems downloading a file, check if you have the
proper application to
view it first. Information about this may be contained
in the File-Format links below. In case of further problems read
the IDEAS help
file. Note that these files are not on the IDEAS
site. Please be patient as the files may be large.
As the access to this document is restricted, you may want to look for a different version under "Related research" (further below) or search for a different version of it.
Publisher Info
Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number
10070.
Length: Date of creation: Nov 2003 Date of revision: Handle: RePEc:nbr:nberwo:10070
Note: CF ME Contact details of provider: Postal: National Bureau of Economic Research, 1050 Massachusetts Avenue Cambridge, MA 02138, U.S.A. Phone: 617-868-3900 Email: Web page: http://www.nber.org More information through EDIRC
For technical questions regarding this item, or to correct its listing, contact: ().
Find related papers by JEL classification: G2 - Financial Economics - - Financial Institutions and Services E5 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit
This paper has been announced in the following NEP Reports:
References listed on IDEAS Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.:
Franklin Allen & Douglas Gale, 1998.
"Optimal Financial Crises,"
Journal of Finance,
American Finance Association, vol. 53(4), pages 1245-1284, 08.
[Downloadable!] (restricted)
Other versions:
Cited by: (explanations, Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.)