In this paper, we analyze a banking crisis, subsequent debt deflation, and the policy responses to the crisis in a model where fi at currency is introduced and contracts are made in nominal terms.
In the recent theoretical research on banking crises, many theories have been proposed concerning the mechanism by which financial crises occur (Diamond and Dybvig[1983], Postlewaiteand Vives[1987], and Allen and Gale [1998,2000,2001]). But there are not so many theories that explain the difference of recovery paths from the crises in accordance with different policy responses. For example, Diamond and Dybvig (1983), Freixas, Parigi, and Rochet (1999), and Martin (2001) discuss the policies to prevent bank runs, but not policy responses to bank insolvency. Only a few authors like Diamond and Raj an (2002a, b), Bergoeing, et al. (2002), and Boyd, Chang, and Smith (2000) consider expostpolicy responses to financial crises.
The world has experienceda large number of banking crises in the last three decades. Caprioand Klingebiel (1999) identified 113 systemic banking crises that had occurred in 93countries since the late 1970s, along with 50 borderline and smaller banking crises in 44countries over the same period. In analyzing these experiences, researchers have come to pay more attention to bank insolvency than to bank runs. Recent crisis episodes suggest that bank insolvency is the central problem to be rectified and that a temporary shortage of liquidity is basicallya symptom. Diamond and Raj an (2002a) also refer to the theoretical possibility of two-way linkage between bank insolvency and liquidity shortages.
One common observation concerning financial crises is the decline of the inflation rate after the onset of a banking crisis (Boydetal. [2001]). The United States experienced severe deflation associated with a rash of bank failures in the 1930s, and Japan is now experiencinga bout of deflation following the onset of a banking crisis in the late 1990s. Boydetal.(2001) show that the onset of a banking crisis decreases the growth rate of M2, which is a significant element contributing to inflation. The low inflation or deflation associated withabanking crisis maybe modeled as debt deflation (Fisher[1933]). In this paper we formalize the notion of debt de flat ion in as imple model.
