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Equilibrium Analysis, Banking and Financial Instability

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  • Dimitrios P Tsomocos

Abstract

This paper first extends the canonical General Equilibrium with Incomplete Markets (GEI) model with money and default to allow for competitive banking and financial instability. Second, it introduces capital requirements for the banking sector to assess the short and medium term macroeconomic consequences of the proposed New Basel Accord. Monetary Equilibria with Commercial Banks and Default (MECBD) exist and financial instability and default emerge as equilibrium phenomena. A non-trivial quantity theory of money is derived and the term structure of interest rates incorporates both the `expectations` and the `liquidity preference` hypotheses. Thus, monetary, fiscal and regulatory policies necessarily generate real effects. Non-neutrality relies upon the real and nominal determinacy of MECBD. A version of the liquidity trap holds and the Diamond-Dybvig (1983) result is a special case. Finally, because of the presence of capital requirements for banks, a trade off exists between regulatory policy and efficiency. The model provides a useful analytical device for policy analysis of situations in which crisis prevention and management become necessary to reduce the risks and costs of financial instability.

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Bibliographic Info

Paper provided by University of Oxford, Department of Economics in its series Economics Series Working Papers with number 2003-FE-08.

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Date of creation: 01 Jan 2000
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Handle: RePEc:oxf:wpaper:2003-fe-08

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Keywords: Financial instability; competitive banking; capital requirements; Basel accord; regulation; incomplete markets; default; non-neutrality; Gains-to-Trade;

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References

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  1. John Geanakoplos & Andreu Mas-Colell, 1985. "Real Indeterminacy with Financial Assets," Cowles Foundation Discussion Papers, Cowles Foundation for Research in Economics, Yale University 770R, Cowles Foundation for Research in Economics, Yale University, revised Oct 1985.
  2. GRANDMONT, Jean-Michel & YOUNES, Yves, . "On the efficiency of a monetary equilibrium," CORE Discussion Papers RP, Université catholique de Louvain, Center for Operations Research and Econometrics (CORE) -135, Université catholique de Louvain, Center for Operations Research and Econometrics (CORE).
  3. Robert E. Lucas Jr. & Nancy L. Stokey, 1984. "Money and Interest in Cash-In-Advance Economy," Discussion Papers, Northwestern University, Center for Mathematical Studies in Economics and Management Science 628, Northwestern University, Center for Mathematical Studies in Economics and Management Science.
  4. Hart, Oliver D., 1975. "On the optimality of equilibrium when the market structure is incomplete," Journal of Economic Theory, Elsevier, Elsevier, vol. 11(3), pages 418-443, December.
  5. repec:fth:louvco:0044 is not listed on IDEAS
  6. John Geanakoplos & Dimitri P. Tsomocos, 2001. "International Finance in General Equilibrium," Cowles Foundation Discussion Papers, Cowles Foundation for Research in Economics, Yale University 1313, Cowles Foundation for Research in Economics, Yale University.
  7. Tobin, James, 1982. " The Commercial Banking Firm: A Simple Model," Scandinavian Journal of Economics, Wiley Blackwell, Wiley Blackwell, vol. 84(4), pages 495-530.
  8. Willem H. Buiter, 2002. "The Fiscal Theory Of The Price Level: A Critique," Economic Journal, Royal Economic Society, Royal Economic Society, vol. 112(481), pages 459-480, July.
  9. Franklin Allen & Douglas Gale, 1998. "Optimal Financial Crises," Journal of Finance, American Finance Association, American Finance Association, vol. 53(4), pages 1245-1284, 08.
  10. Radner, Roy, 1972. "Existence of Equilibrium of Plans, Prices, and Price Expectations in a Sequence of Markets," Econometrica, Econometric Society, Econometric Society, vol. 40(2), pages 289-303, March.
  11. Bewley, Truman, 1983. "A Difficulty with the Optimum Quantity of Money," Econometrica, Econometric Society, Econometric Society, vol. 51(5), pages 1485-504, September.
  12. Pradeep Dubey & John Geanakoplos, 2003. "Monetary Equilibrium with Missing Markets," Cowles Foundation Discussion Papers, Cowles Foundation for Research in Economics, Yale University 1389, Cowles Foundation for Research in Economics, Yale University.
  13. Dubey, Pradeep & Geanakoplos, John, 2003. "Monetary equilibrium with missing markets," Journal of Mathematical Economics, Elsevier, vol. 39(5-6), pages 585-618, July.
  14. M. Shubik & D. Tsomocos, 1992. "A strategic market game with a mutual bank with fractional reserves and redemption in gold," Journal of Economics, Springer, Springer, vol. 55(2), pages 123-150, June.
  15. Grandmont, Jean-Michel & Younes, Yves, 1972. "On the Role of Money and the Existence of a Monetary Equilibrium," Review of Economic Studies, Wiley Blackwell, Wiley Blackwell, vol. 39(3), pages 355-72, July.
  16. Pradeep Dubey & John Geanakoplos & Martin Shubik, 2000. "Default in a General Equilibrium Model with Incomplete Markets," Cowles Foundation Discussion Papers, Cowles Foundation for Research in Economics, Yale University 1247, Cowles Foundation for Research in Economics, Yale University.
  17. DREZE, Jacques & POLEMARCHAKIS, Heracles, 1995. "Monetary equilibria," CORE Discussion Papers, Université catholique de Louvain, Center for Operations Research and Econometrics (CORE) 1995078, Université catholique de Louvain, Center for Operations Research and Econometrics (CORE).
  18. Lucas, Robert E, Jr, 1980. "Equilibrium in a Pure Currency Economy," Economic Inquiry, Western Economic Association International, Western Economic Association International, vol. 18(2), pages 203-20, April.
  19. Hool, Bryce, 1976. "Money, Expectations and the Existence of a Temporary Equilibrium," Review of Economic Studies, Wiley Blackwell, Wiley Blackwell, vol. 43(3), pages 439-45, October.
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