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Financial Instability with Circulating Debt Claims and Endogenous Debt Limits

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  • Daniel R. Sanches

Abstract

This paper develops a banking model in which intermediaries issue liabilities that circulate as a medium of exchange to finance loans to entrepreneurs, who use the proceeds to fund the accumulation of capital goods. The issuance of circulating liabilities, together with endogenous debt limits, gives rise to a franchise value for intermediaries. A competitive equilibrium with endogenous debt limits admits allocations that are characterized by a funding crisis and a self-fulfilling collapse of the banking system, with the intermediary’s franchise value eroding over time. In view of these difficulties, I construct a sophisticated fiscal policy that provides a government guarantee for the franchise value, which results in the determinacy of equilibrium, with the constrained efficient allocation emerging as the unique outcome.

Suggested Citation

  • Daniel R. Sanches, 2020. "Financial Instability with Circulating Debt Claims and Endogenous Debt Limits," Working Papers 20-45, Federal Reserve Bank of Philadelphia.
  • Handle: RePEc:fip:fedpwp:89107
    DOI: 10.21799/frbp.wp.2020.45
    as

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    More about this item

    Keywords

    circulating bank liabilities; endogenous debt limits; franchise value; funding crisis; government guarantee;
    All these keywords.

    JEL classification:

    • E42 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Monetary Sytsems; Standards; Regimes; Government and the Monetary System
    • E44 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Financial Markets and the Macroeconomy
    • G21 - Financial Economics - - Financial Institutions and Services - - - Banks; Other Depository Institutions; Micro Finance Institutions; Mortgages

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