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Equilibrium analysis, banking and financial instability

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  • Tsomocos, Dimitrios P.

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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Suggested Citation

  • Tsomocos, Dimitrios P., 2003. "Equilibrium analysis, banking and financial instability," Journal of Mathematical Economics, Elsevier, vol. 39(5-6), pages 619-655, July.
  • Handle: RePEc:eee:mateco:v:39:y:2003:i:5-6:p:619-655
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    More about this item

    JEL classification:

    • D52 - Microeconomics - - General Equilibrium and Disequilibrium - - - Incomplete Markets
    • E4 - Macroeconomics and Monetary Economics - - Money and Interest Rates
    • E5 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit
    • G1 - Financial Economics - - General Financial Markets
    • G2 - Financial Economics - - Financial Institutions and Services

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