Academic journal article Economic Quarterly - Federal Reserve Bank of Richmond

Inside-Money Theory after Diamond and Dybvig

Academic journal article Economic Quarterly - Federal Reserve Bank of Richmond

Inside-Money Theory after Diamond and Dybvig

Article excerpt

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This article argues that the model in Diamond and Dybvig (1983, DD hereafter) was a significant conceptual and methodological advance in studying banking arrangements. Its methodological contribution was the use of mechanism-design theory rather than the old strategy, still prevalent in textbooks and some of macro, of tacking a banking sector onto a model of market exchange. A great deal of attention has been given to the model's multiple equilibria and interpreting them as financial fragility. This attention is warranted, but there are other less recognized implications of the model. I provide examples in which the model is used to address banker incentives and means of payment. I also show how its methodology is related to recent work that uses monetary models to consider money, credit, and imperfect monitoring.

Recent events provide a good opportunity to put into perspective progress in the field of money and banking. The idea that banks are inherently unstable is as old as the field itself. The recent economic crisis in the United States and around the world was met by a new generation of central bankers familiar with the notion of financial fragility in DD. The dramatic increase in the balance sheet of the Fed, for instance, led by the purchasing of private securities whose markets had virtually disappeared, seems to indicate that financial meltdowns may not be restricted to unique conditions like those of the Great Depression.1

Overall, the DD framework is a model of intertemporal trade with relatively few variables. It allows for a sharp description of frictions that private information and sequentiality of transactions imposed on the provision of insurance against preference shocks. This tractability emphasizes the question of whether or not optimal allocations are implemented uniquely, that is, whether or not the optimum is fragile to runs. A less appreciated issue, and my focus here, is how the DD framework suits developments in monetary theory that emphasize imperfect monitoring.

Micro and Macro Mechanisms

Findings about the multiplicity of equilibrium outcomes are common in the field of money and banking. Expectations about future behavior are important for the current value of money and its substitutes. While this property tends to raise the possibility of multiple outcomes, precise conclusions depend heavily on assumptions about what is traded and how markets are organized. There is an old habit in macroeconomics of building models around institutions seen empirically as important devices with which to organize savings: deposits, bonds, capital, alternative currencies, etc. DD represent a new modeling approach with their use of a very compact model of the pooling and intertemporal redistribution of resources in a single resource-constraint world. A bonus of this minimalist approach is the speed at which the literature identifies key elements that drive the role for liquidity provision and the possibility of financial fragility in their theory. These elements, taken as immutable primitives, rule out remedies like deposit insurance that even DD point to in their title.

Reviewing theDDcontribution on the basis of this sort of "micro" problem alone is attractive because of the sharp results achieved by follow-up work. This can be appreciated by the material I present in Section 3, which follows an informal summary of model choices in Section 2. In addition to the emphasis on the issue of multiplicity guided by the model of Green and Lin (2003), I make considerations about imperfect monitoring that are inspired by the model of Prescott and Weinberg (2003). In Section 4, those considerations provide a bridge to identify monitoring in models where banks are people, which is different from the original DD setup. Examples include the models of Calomiris and Kahn (1991) and Deviatov and Wallace (2009). The latter, a monetary model, leads us to much larger mechanisms in macroeconomics. …

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