Discussion Paper Series 2014-E-7

Banking, Liquidity and Bank Runs in an Infinite Horizon Economy

Mark Gertler, Nobuhiro Kiyotaki

We develop a variation of the macroeconomic model of banking in Gertler and Kiyotaki (2011) that allows for liquidity mismatch and bank runs as in Diamond and Dybvig (1983). As in Gertler and Kiyotaki, because bank net worth fluctuates with aggregate production, the spread between the expected rates of return on bank assets and deposits fluctuates countercyclically. However, because bank assets are less liquid than deposits, bank runs are possible as in Diamond and Dybvig. Whether a bank run equilibrium exists depends on bank balance sheets and an endogenous liquidation price for bank assets. While in normal times a bank run equilibrium may not exist, the possibility can arise in a recession. We also analyze the effects of anticipated bank runs. Overall, the goal is to present a framework that synthesizes the macroeconomic and microeconomic approaches to banking and banking instability.

Keywords: Financial Intermediation; Liquidity Mismatch; Financial Accelerator; Rollover Risk

Views expressed in the paper are those of the authors and do not necessarily reflect those of the Bank of Japan or Institute for Monetary and Economic Studies.

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