Financial Crises and Systemic Bank Runs in a Dynamic Model of Banking

What are the effects of unconventional monetary policies during panic-based financial crises? To address this question, I develop a dynamic general equilibrium model of banking. A novel mechanism gives rise to multiple equilibria. In the good equilibrium, all banks are solvent. In the bad equilibrium, many banks are insolvent and subject to runs. The bad equilibrium is also characterized by deflation and by a flight to liquidity (i.e., depositors are willing to hold more money and less deposits in comparison to the good equilibrium). I consider two types of monetary injections: loans to banks and asset purchases. Both policies counteract deflation and reduce the losses of insolvent banks, but two novel implications are salient. First, for some parameter values, a temporary increase of money supply (implemented using either loans to banks or asset purchases) amplifies the flight to liquidity. Second, asset purchases preclude a crisis only if the central bank is committed to creating inflation in the event of a panic. JEL Codes: E44, E52, G01, G21 ∗Department of Economics, University of Chicago, 1126 East 59th Street, Chicago, IL 60637 (E-mail: [email protected]). I am grateful to Fernando Alvarez, Veronica Guerrieri, Robert Lucas, and Harald Uhlig for suggestions and guidance, and to Ana Babus, Gadi Barlevy, Philip Barrett, Martin Beraja, Maryam Farboodi, Kinda Hachem, Lars Hansen, Stefanie Stantcheva, Pietro Veronesi, seminar participants at BFI Financial Markets and Contracts Graduate Student Conference, Chicago FED, EIEF, Macro-Financial Modeling Group Meetings and University of Chicago for comments. I thank the Becker-Friedman Institute and the Macroeconomic Modeling and Systemic Risk Research Initiative for financial support. †UPDATES: https://sites.google.com/site/robertorobatto/papers/Robatto_JMP.pdf