Money in a Theory of Banking - haas.berkeley.edu.pdf

First draft: September 2002 Revised: February 2003 Please do not quote without permission Money in a Theory of Banking Douglas W. Diamond Raghuram G. Rajan University of Chicago University of Chicago and NBER and NBER Abstract We explore the connection between money, banks, and aggregate credit by introducing money in a simple “real” model of banking. Because of the nature of their business, banks are susceptible to aggregate shortages of consumption goods. We find that under very special circumstances, banks can insure themselves against these destructive shortages by issuing nominal deposits (i.e., denominated in money) instead of real deposits. In general, however, banks will not be completely insured. In fact, by issuing nominal demand deposits, banks leave themselves exposed to significant increases in their real repayment burden if there is a shortfall of money. This could exacerbate shortages and lead to a severe contraction in credit. Our analysis makes transparent how change s in the supply of money can work through banks to affect real economic activity. It also suggests how bank failures could lead to a fall in prices and a contagion of bank failures, as described by Friedman and Schwartz (1963). We are grateful for financial support from the National Science Foundation and the Center for Research on Security Prices. Rajan also thanks the Center for the Study of the State and the Economy for financial support. We thank John Cochrane, Jeff Lacker and Jeremy Stein for helpful conversations on this topic. W