Equilibrium Analysis, Banking, and Financial Instability

Tsomocos, Dimitrios (2003) Equilibrium Analysis, Banking, and Financial Instability. Journal of Mathematical Economics, 39 (5-6). pp. 619-655.


This paper first extends the canonical General Equilibrium with Incomplete Markets (GEI) model with money and default to allow for competitive banking and financial instability. Second, it introduces capital requirements for the banking sector to assess the short and medium term macroeconomic consequences of the proposed New Basel Accord. Monetary Equilibria with Commercial Banks and Default (MECBD) exist and financial instability and default emerge as equilibrium phenomena. A non-trivial quantity theory of money is derived and the term structure of interest rates incorporates both the ‘expectations’ and the ‘liquidity preference’ hypotheses. Thus, monetary, fiscal and regulatory policies necessarily generate real effects. Non-neutrality relies upon the real and nominal determinacy of MECBD. A version of the liquidity trap holds and the Diamond and Dybvig [J. Pol. Econ. 91 (1983) 401] result is a special case. Finally, because of the presence of capital requirements for banks, a trade off exists between regulatory policy and efficiency. The model provides a useful analytical device for policy analysis of situations in which crisis prevention and management become necessary to reduce the risks and costs of financial instability.

Item Type: Article
Keywords: Financial instability; Competitive banking; Capital requirements; Basel accord; Regulation; Incomplete markets; Default; Non-neutrality; Gains-to-trade; finance
Subject(s): Finance
Date Deposited: 25 Jan 2012 19:15
Last Modified: 09 Mar 2017 14:04
URI: http://eureka.sbs.ox.ac.uk/id/eprint/1865

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