Deposit Money Creation in Search Equilibrium

The endogenous creation of bank credit and of deposit money is modeled. If banks have a limited ability to commit to making interbank loans, then, in order for bank deposits to be accepted as liquid assets, an upper bound is placed upon the size of each bank's asset portfolio, where the bound is determined as a certain multiple of the bank's capital. In our search model, the Central Limit Theorem implies that the multiplier is a non-linear function of the aggregate level of bank assets. Thus when banks have little capital, there emerges an inefficient equilibrium where the production level is low and unemployment exists. In the case where the initial value of bank capital is small and pessimistic macroeconomic expectations prevail, the economy converges on the unemployment equilibrium even if prices are flexible.