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Demand-deposit contracts

1.1 The environment

A continuum of consumers with preferences

u (c1 , c2 ) = u (c1 + c2 )

1

As you know, this requires abusing the law of large numbers. See Judd [1985] on why this is a problem and

Uhlig [1996] on how to fix it.

1

Econ 235, Spring 2013 Pablo Kurlat

investment can be terminated early (liquidated) at t = 1. If z y units are liquidated,

then the investment yields z goods at t = 1 and R (y z) goods at t = 2. Assume

1.

Note: original paper has = 1, so the storage technology is redundant the ex-ante choice

of technology is not the main issue.

Assume (its easy to prove) that the solution is symmetrical, that it involves early consumers

consuming at t = 1 and late consumers consuming at t = 2 and that no long-term projects

are liquidated

c1 ,c2 ,x,y

s.t. c1 x

(1 ) c2 Ry

x+y =1

or equivalently

c1 ,c2 ,x,y

c2

s.t. c1 + (1 ) 1

R

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.

2

Econ 235, Spring 2013 Pablo Kurlat

Markets for consumption at t = 1 and t = 2 contingent on realization of for each individual.

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 )

c1 ,c2

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

Suppose there are no insurance markets

The only market is at t = 1, where agents can trade t = 1 goods against t = 2 goods (or,

equivalently, ongoing projects)

3

Econ 235, Spring 2013 Pablo Kurlat

c1 ,c2 ,x,y

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.

c1 ,c2

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)

4

Econ 235, Spring 2013 Pablo Kurlat

R

0 0 cu0 (c)

Ru (R) = u (1) + dc

1 c

R

= u0 (1) + [cu00 (c) + u0 (c)] dc

1

R 00

0 0 cu (c)

= u (1) + u (c) + 1 dc

1 u0 (c)

< u0 (1)

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

5

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!

One variant of the contract can rule out the bad equilibrium

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

2

These payoffs are accurate for the case where f , which will be true in equilibrium because all impatient

consumers withdraw. To be fully correct you have to take into account that if f < you need to use storage

between t = 1 and t = 2

3

Again, you would need to take into account what happens if f <

6

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.

2.1 Who needs a bank?

Suppose instead of a bank consumers set up a firm

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=

7

Econ 235, Spring 2013 Pablo Kurlat

(1)d1 if p < d2

p

D=

0 otherwise

Market clearing:

(1 ) d1

=

p

(1 ) d1

p= = (1 ) cF1 B

c1 = d1 + p = cF1 B

d1

c2 = d 2 1 +

p

cF1 B

FB

= (1 ) c2 1+

(1 ) cF1 B

= cF2 B

then it is the case that deposit contracts improve upon the dividend arrangement

The constrained efficient allocation, if the first best is not incentive compatible

while shares can only do so under quite restrictive assumptions, which happen to hold in the

original model

8

Econ 235, Spring 2013 Pablo Kurlat

Suppose that, after a bank/firm is set up, at t = 1 a market opens where consumers can

trade t = 2 goods against t = 1 goods

cF B

Therefore the price of t = 2 goods in terms of t = 1 goods must be p = 1

cF B. (Do not confuse

2

this price with the price of shares in the firm)

Invest in the long term technology

If you are impatient, sell your long term project at t = 1

If you are patient, hold on to your project and consume at t = 2

This delivers

cF1 B

c1 = Rp = R > cF1 B

cF2 B

c2 = R > cF2 B

Pecuniary externality:

goods more abundant

This is good for insurance purposes (it makes up for the missing insurance market)

Without restrictions, individuals do not internalize the externality so they invest in

long-term projects rather than in the bank

Restrictions on trading are needed to sustain these insurance-like arrangements. Are they

reasonable?

9

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.

10

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