10. Monetary Policy and Financial Stability

Deposit contracts can provide efficient insurance against idiosyncratic household liquidity risks (which is not modelled here explicitly), but they induce fragility due to the risk of bank runs in case of adverse aggregate shocks. In Diamond and Dybvig (1983) the risk of runs is the result of a sequential service constraint (leaving those late in the queue empty-handed). But bank runs can occur even if all depositors are treated equally (receiving the same haircut) provided they anticipate that the bank will be left with zero net worth in the event of a run such that \( {x}_{t+1}<1 \).

If the central bank lacks credibility in implementing price stability in the long run, sovereign countries may also suffer from self-fulfilling inflationary expectations. Inspired by the experience in the Latin American debt crisis, Calvo (1988) showed that with nominal bonds multiple, self-fulfilling equilibria with either low or high expected inflation may prevail. See also Corsetti and Dedola (2016).

Holmström and Tirole (1998) provide an alternative micro-foundation to evaluate private and public liquidity provision. In their model, private firms suffer from liquidity shocks, struggling to get external funds to finance valuable projects. They show that credit lines from financial intermediaries can implement the socially efficient (second-best) allocation in the absence of aggregate shocks (firms’ liquidity shocks being independent). With aggregate uncertainty, private provision of liquidity is insufficient, so government-provided liquidity can improve the allocation by committing future tax income to back up the reimbursements. Holmström and Tirole (1998) consider a real model with public finance interventions via lump-sum taxation. They assume that the government has unlimited power to tax real resources and so is always able to redistribute resources ex post.