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Demand-deposit contracts
u (c1 , c2 ) = u (c1 + c2 )
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Econ 235, Spring 2013 Pablo Kurlat
Note: original paper has = 1, so the storage technology is redundant the ex-ante choice
of technology is not the main issue.
s.t. c1 x
(1 ) c2 Ry
x+y =1
or equivalently
FOC:
u0 (c1 ) = 0
1
(1 ) u0 (c2 ) (1 ) = 0
R
so
u0 (c1 )
=R (1)
u0 (c2 )
MRS = MRT
What if types are not observable? Planner can set up a mechanism: declare your type
(early or late) and you get a consumption bundle in return.
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Econ 235, Spring 2013 Pablo Kurlat
Assume (its easy to prove) again that in equilibrium the agent only buys positive amounts
of the following contingent claims: c1 if impatient (at price p1 ) and c2 if patient (at price
p2 )
s.t. p1 c1 + p2 c2 1
with FOC:
u0 (c1 ) 1 p1
0
=
u (c2 ) p2
By using the LLN, firms can transform one unit of t = 0 goods into 1 units of the contingent
R
claim c1 if impatient, or into 1 units of the contingent claim c2 if patient . Competition
implies
p1 =
1
p2 =
R
Therefore
u0 (c1 )
=R
u0 (c2 )
and we recover the first best allocation.
(Theres nothing special about this, it just illustrates the Second Welfare Theorem)
Anything other than this which arises in the model must be a result of some form of market
incompleteness
The only market is at t = 1, where agents can trade t = 1 goods against t = 2 goods (or,
equivalently, ongoing projects)
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Econ 235, Spring 2013 Pablo Kurlat
s.t. c1 x + pRy
x
c2 Ry +
p
x+y =1
1
p=
R
If p > R1 , then it is always preferable to invest in the long-term technology at t = 0, but then
all early consumers will be trying to sell at t = 1 and nobody would buy
If p < R1 , then it is always preferable to invest in storage at t = 0, but then all late consumers
would be willing to pay 1 for t = 2 goods, so p < R1 cannot be the equilibrium price.
s.t. c1 1
c2 R
The allocation
c1 = 1 c2 = R
Assume that the consumer is more risk averse than log, i.e.
u00 (c) c
> 1 c
u0 (c)
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Econ 235, Spring 2013 Pablo Kurlat
1.5 A bank
Consumers get together and create a bank
They each deposit their endowment with the bank, which invests the first best amount in
each technology
The bank sets up the following contract: each consumer can ask for cF1 B at t = 1, or can
wait until t = 2 and get a pro-rata share of whatever is left.
Demand deposit
The bank commits to satisfying sequential service: satisfy consumers withdrawals in the
order in which they arrive (which, assume, is random)
If the stored goods are not enough to satisfy a consumer who demands payment, then the
bank must liquidate the long-term investment until that, too, runs out.
Consumers then play a game, where the actions are withdraw or wait (or you could allow
for partial withdrawal, it doesnt matter)
Let
fj be the number of depositors who arrived in line before consumer j and asked to
withdraw and
f be the total number of consumers that will eventually ask to withdraw
Withdraw Wait
c F B if cF1 B fj < xF B + y F B
1
0
0 otherwise
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Econ 235, Spring 2013 Pablo Kurlat
Withdraw Wait
c F B if cF1 B fj < xF B + y F B 1 FB
1cF B
n o
1 1 (f ) c1
max R 1f
,0
0 otherwise
The symmetric straegy profile withdraw iff impatient is a Nash equilibrium, with payoffs
equal to the first best allocation.
Impatient consumers dont want to deviate because they dont care about future con-
sumption
Patient consumers dont want to deviate because cF2 B > cF1 B
The symmetric strategy profile withdraw no matter what is also a Nash equilibrium
Given that cF1 B > 1 xF B + y F B , if everyone tries to withdraw the money will run
out
Therefore anyone who waits will obtain zero
This justifies withdrawing
This equilibrium produces a very bad allocation!
The contract states that you can withdraw cF1 B at t = 1 as long as less than other consumers
have withdrawn before you. After that, you are forced to wait
Withdraw Wait
cF B if f <
1 j
0
0 otherwise
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Econ 235, Spring 2013 Pablo Kurlat
Withdraw Wait
cF B if f <
1 j
cF2 B
0 otherwise
So now waiting is dominant for patient consumers, and runs will not take place.
1.7 Remarks
Liquidity transformation as a form of insurance, not provided by narrow banking [Wallace,
1996]
What is the reason for the sequential-service constraint? What does it mean [Wallace, 1988,
Green and Lin, 2003, Ennis and Keister, 2009]?
Chicken models and the why doesnt the government just do everything argument.
The firm invests the first-best amount and issues shares. Each consumer gets one share
It declares the following dividend policy: a dividend of d1 = cF1 B will be paid at t = 1 and
a dividend of d2 = (1 ) cF2 B will be paid at t = 2
Consumers can trade shares in the firm at t = 1 (they trade ex-dividend - after paying
dividends) at a price of p goods per share.
S=
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Econ 235, Spring 2013 Pablo Kurlat
Market clearing:
(1 ) d1
=
p
(1 ) d1
p= = (1 ) cF1 B
c1 = d1 + p = cF1 B
then it is the case that deposit contracts improve upon the dividend arrangement
while shares can only do so under quite restrictive assumptions, which happen to hold in the
original model
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Econ 235, Spring 2013 Pablo Kurlat
This delivers
cF1 B
c1 = Rp = R > cF1 B
cF2 B
c2 = R > cF2 B
Pecuniary externality:
Restrictions on trading are needed to sustain these insurance-like arrangements. Are they
reasonable?
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Econ 235, Spring 2013 Pablo Kurlat
References
W. Diamond, Douglas and Philip H. Dybvig. Bank runs, deposit insurance, and liquidity. Journal
of Political Economy, 91(3):401419, June 1983.
Huberto M. Ennis and Todd Keister. Run equilibria in the green-lin model of financial intermedi-
ation. Journal of Economic Theory, 144(5):1996 2020, 2009.
Edward J. Green and Ping Lin. Implementing efficient allocations in a model of financial interme-
diation. Journal of Economic Theory, 109:123, March 2003.
Charles J. Jacklin. Demand deposits, trading restrictions, and risk sharing. In Edward C. Prescott
and Neil Wallace, editors, Contractual arrangements for intertemporal trade, pages 2647. Uni-
versity of Minnesota Press, 1987.
Kenneth L. Judd. The law of large numbers with a continuum of iid random variables. Journal of
Economic Theory, 35(1):1925, February 1985.
Harald Uhlig. A law of large numbers for large economies. Economic Theory, 8(1):4150, 1996.
Neil Wallace. Another attempt to explain an illiquid banking: the diamond-dybvig model with
sequential service taken seriously. Federal Reserve Bank of Minneapolis Quarterly Review, 12:
316, 1988.
Neil Wallace. Narrow banking meets the diamond-dybvig model. Federal Reserve Bank of Min-
neapolis Quarterly Review, 20(1):313, 1996.
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