This paper first extends the canonical General Equilibrium with
Incomplete Markets (GEI) model with money and default to allow for
competitive banking and financial instability. Second, it introduces
capital requirements for the banking sector to assess the short and medium
term macroeconomic consequences of the proposed New Basel Accord. Monetary Equilibria with Commercial Banks and Default (MECBD) exist
and financial instability and
default emerge as equilibrium phenomena.
A non-trivial quantity theory of money is derived and the term structure
of interest rates incorporates both the 'expectations' and the 'liquidity
preference' hypotheses. Thus, monetary, fiscal and regulatory policies
necessarily generate real effects. Non-neutrality
relies upon the real and nominal determinacy of MECBD.
A version of the liquidity trap holds and the Diamond-Dybvig (1983)
result is a special case. Finally, because of the presence of capital
requirements for banks, a trade off exists between regulatory policy and
The model provides a useful analytical device for policy analysis of
situations in which crisis
prevention and management become necessary to reduce the risks and
costs of financial instability.
Keywords: Financial instability, competitive banking, capital
requirements, Basel accord, regulation, incomplete markets, default,
D52, E4, E5, G1, G2.
here to download paper (725 kB)