Self-fulfilling runs and endogeneous liquidity creation

Abstract

This paper incorporates endogenous money creation into the liquidity mismatch problem of Diamond and Dybvig (1983). We characterize a nominal economy where demandable deposits are created through lending. Depositors use sight deposits to buy consumption goods and the banks manage reserves to clear payments and to offset liquidity risk. We show that deposit contracts are suboptimal in terms of liquidity risk-sharing. We also observe that the self-fulfilling run depends on the refinancing rate of the central bank. Our analysis emphasizes the importance of effective lender of last resort policies to prevent expectational banking panics.