Working Paper: CEPR ID: DP8553
Authors: Franklin Allen; Elena Carletti; Douglas M. Gale
Abstract: Most analyses of banking crises assume that banks use real contracts. However, in practice contracts are nominal and this is what is assumed here. We consider a standard banking model with aggregate return risk, aggregate liquidity risk and idiosyncratic liquidity shocks. We show that, with non-contingent nominal deposit contracts, the first-best efficient allocation can be achieved in a decentralized banking system. What is required is that the central bank accommodates the demands of the private sector for fiat money. Variations in the price level allow full sharing of aggregate risks. An interbank market allows the sharing of idiosyncratic liquidity risk. In contrast, idiosyncratic (bank-specific) return risks cannot be shared using monetary policy alone; real transfers are needed.
Keywords: monetary policy; nominal contracts
JEL Codes: E42; E44; E52; E58
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| central bank's accommodation of demand for fiat money (E58) | decentralized banking system achieves first-best efficiency (E58) |
| variations in price level (E30) | full sharing of aggregate risks (G22) |
| monetary policy can address aggregate liquidity and asset return shocks (E44) | mitigate idiosyncratic bank-specific asset return risks (G21) |
| monetary policy alone cannot fully mitigate idiosyncratic bank-specific asset return risks (E44) | necessitating real transfers for complete risk sharing (D52) |