IED Discussion Paper Series No.94

Financial Fragility in a Monetary Economy: Positive Implications and Policy Prescriptions

We analyze financial collapses, such as the one that occurred during the U.S. Great Depression, from the perspective of a monetary model with multiple equilibria. The economy we consider contains financial fragility due to increasing returns to scale in the intermediation process. Intermediaries provide the link between savers and firms who require working capital for production. Fluctuations in the intermediation process are driven by variations in the confidence agents place in the finanical system. From a positive perspective, our model matches quite closely the qualitative changes in some financial and real variables (the currency/deposit ratio, ex-post interest rates, the level of intermediated activity, deflation, employment and production) over the Great Depression period, an experience often attributed to financial collapse. From a normative perspective, we argue that interventions, such as increases in the money supply, are sufficient to overcome strategic uncertainty and thus avoid financial collapse.