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Equilibrium Analysis, Banking and Financial Instability

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  • Dimitrios P. Tsomocos

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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.

Suggested Citation

  • Dimitrios P. Tsomocos, 2003. "Equilibrium Analysis, Banking and Financial Instability," OFRC Working Papers Series 2003fe08, Oxford Financial Research Centre.
  • Handle: RePEc:sbs:wpsefe:2003fe08
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    File URL: http://www.finance.ox.ac.uk/file_links/finecon_papers/2003fe08.pdf
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    References listed on IDEAS

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    1. Jean-Michel Grandmont & Yves Younes, 1973. "On the Efficiency of a Monetary Equilibrium," Review of Economic Studies, Oxford University Press, vol. 40(2), pages 149-165.
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    3. Dubey, Pradeep & Geanakoplos, John, 2003. "Monetary equilibrium with missing markets," Journal of Mathematical Economics, Elsevier, vol. 39(5-6), pages 585-618, July.
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    5. Bryce Hool, 1976. "Money, Expectations and the Existence of a Temporary Equilibrium," Review of Economic Studies, Oxford University Press, vol. 43(3), pages 439-445.
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    17. Pradeep Dubey & John Geanakoplos & Martin Shubik, 2000. "Default in a General Equilibrium Model with Incomplete Markets," Cowles Foundation Discussion Papers 1247, Cowles Foundation for Research in Economics, Yale University.
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    More about this item

    Keywords

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

    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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