A General Equilibrium Model of Banking Crises

The objective of this work in progress is to endogenise the firm sector in the classic Diamond Dybvig setup. This should better able us to understand how shocks are transmitted within sectors. 1 The basic setup and the players • Consider an economy with three periods, t = 0, 1, 2. • There exists a single divisible consumption good in each period. • There are three types of agents: depositors, financial intermediaries or banks, and entrepreneurs. • All agents are risk neutral. • All lenders (depositors and banks) have access to a risk free storage technology such that one unit of good at t = 0 becomes (1+ r) units at t = 2. • There also exist alternative short term storage technologies such that one unit of the good at t = 0 becomes (1 + r0,1) units at t = 1, and one unit of the good at t = 1 becomes (1 + r1,2) units at t = 2. We therefore have (1 + r0,1) (1 + r1,2) = (1 + r). These technologies are available to both the banks and the investors. 1.1 Entrepreneurs • The economy is populated with a total of T entrepreneurs, each of which has access to a risky technology. • Each entrepreneur has an investment project which requires 1 unit of consumption good. • The entrepreneurs have zero wealth and therefore require funding for their projects.