Banking panics in a dynamic general equilibrium framework

Historically banking panics have been associated with price declines in the United States. In his ”Debt-Deflation theory of the Great Depression ” Fisher hypothesized that banking panics were a consequence of mismatched balance sheets, with the mismatch arising from having liabilities at book value and asset at market value. This paper develops a dynamic general equilibrium model of banks that can be used to analyze Fishers hypothesis. The mechanism at work is a dynamic interaction between depositors and banks based off beliefs about other players ’ future strategies. If banks fear prices to fall in the future, they know they’ll be unable to pay their nominal obligations back. Depositors may be aware of that and run on the bank when facing fears of a decrease in the price level. Hence a banking panic occurs. The model is a version of Lucas-Stockey cash-credit economy with explicit characterization of banks/firms behavior. There exists a sunspot stationary equilibrium that features lower prices when banking panics and defaults occur relative to no panics and no defaults, and such fall in prices is self-fulfilling. Also, in this environment the Friedman and Schwartz insight that during the Great Depression a looser monetary policy would have resulted in a milder cycle applies. If a monetary authority injects money when there are fears of deflation then banks will not default and households will not panic. This framework is also suitable to being calibrated and tested to the data