Date Added: Jan 2011
Most analyses of banking crises assume that banks use real contracts. However, in practice contracts are nominal and this is what is assumed here. The authors consider a standard banking model with aggregate return risk, aggregate liquidity risk and idiosyncratic liquidity shocks. They show that, with non-contingent nominal deposit contracts, the first-best efficient allocation can be achieved in a decentralized banking system. What is required is that the central bank accommodates the demands of the private sector for fiat money. Variations in the price level allow full sharing of aggregate risks. An interbank market allows the sharing of idiosyncratic liquidity risk.