Demand Deposit Contracts, Suspension of Convertibility, and Optimal Financial Intermediation

A P Villamil

Economic Theory, 1991, vol. 1, issue 3, 277-88

Abstract: This paper establishes that an optical contract, combining features of well-known Diamond and Dybvig (1983) and Townsend (1979,1983) models, resembles banking. The contract and the associated allocations are derived from a social planner's problem which contains the Diamond and Dybvig and Townsend models as sub-problems. The analysis accomplishes the following. It unites the liquidity preference and cost minimization literatures in a simple way; resolves the demand deposit/demand equity problem in the Diamond and Dybvig model; introduces a notion of efficient bankruptcies into the liquidity preference literature; and raises some questions about the government regulation vs. laissez faire banking debate.

Date: 1991
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