Opposite policy implications in the theory of money and banking

Abstract

The recent financial crisis creates a demand for welfare-based models of financial regulation and liquidity shortages. In this paper, we review policy implications from two cornerstone models and show that they imply different responses in terms of intertemporal returns of financial liabilities. In the first case, a version of the Cavalcanti and Wallace (1999), random-matching model, monitored agents are led to promote inflation in bank-issued money. In the second case, a sequentialservice version of the Diamond and Dybvig (1983) model of bank runs with insolvency, increases in long-run returns can prevent bank runs by reducing the provision of liquidity.