IN CHAPTER 12, we examined a model economy in which bank insolvency can arise. Two types of bank risk were studied. In one case, banks were passive, becoming insolvent because of the mismatch of illiquid assets and (liquid) deposits payable on demand. In the other case, asset value is subject to random fluctuations, so that in bad states of the world, the bank becomes insolvent because asset value fell relative to liability values. In both cases, the model economy focused on real factors. There was no money in the model economies.

In this chapter, we build a model economy in which monetary factors play an explicit role in bank failures. Our motivation is based on the observation that in actual economies, money is often associated with banking failures. In other words, liquidity shortages, in the form of too little currency, are frequently associated with widespread bank failures, which can turn into banking panics. In this version of the model economy, currency and bank panics are clearly linked. In building this model, we can examine the roles that different regulatory structures play; specifically, we offer an explanation that can account for why some countries experience banking panics and others do not. A key regulatory feature seems to be the restrictions on the issue of currency by private banks.

Money with Limited Communication

Some of the factors present in Chapter 12 are altered. In this model economy, the focal point is on two distinct locations.