Typically banking panics have been associated with deflation and declines in economic activity in the monetary history of the US and other countries. This paper develops a dynamic framework to study the interaction between banking and monetary policy. One result is the presence of multiple equilibria: banking panics and deflation arise at the same time and endogenously as equilibrium outcomes. Deposit contracts are written in nominal terms, so if prices fall relative to what was anticipated at the time the deposit contract was signed, then the real value of banks' existing obligations increases. So banks default, a banking panic precipitates and economic activity declines. If banks default on their deposits the demand for cash in the economy increases, because financial intermediation provided by banks disappears. The price level drops thereby leading banks to default. Friedman-Schwartz hypothesized that if the monetary authority had followed an alternative monetary policy during the early 1930s, aimed at keeping prices constant, banks would have been prevented from failing and output from falling, thus reducing the extent of the cycle. I show that this hypothesis is correct. In this framework a mechanism like deposit insurance, when coupled with strict regulatory arrangements, achieves the same goal as the monetary policy. Absent strict regulatory arrangements however, deposit insurance amplifies business cycle fluctuations by inducing moral hazard.

 

 

Prior to 1863, state-chartered banks in the United States issued notes–dollar-denominated promises to pay specie to the bearer on demand. Although these notes circulated at par locally, they usually were quoted at a discount outside the local area. These discounts varied by both the location of the bank and the location where the discount was being quoted. Further, these discounts were asymmetric across locations, meaning that the discounts quoted in location A on the notes of banks in location B generally differed from the discounts quoted in location B on the notes of banks in location A. Also, discounts generally increased when banks suspended payments on their notes. In this paper we construct a random matching model to qualitatively match these facts about banknote discounts. To attempt to account for locational differences, the model has agents that come from two distinct locations. Each location also has bankers that can issue notes. Banknotes are accepted in exchange because banks are required to produce when a banknote is presented for redemption and their past actions are public information. Overall, the model delivers predictions consistent with the behavior of discounts.