Money, Banking, and Financial Markets

Abstract The fact that money, banking, and financial markets interact in important ways seems self-evident. The theoretical nature of this interaction, however, has not been fully explored. To this end, we integrate the Diamond (1997, Journal of Political Economy105, 928–956) model of banking and financial markets with the Lagos and Wright (2005, Journal of Political Economy113, 463–484) dynamic model of monetary exchange—a union that bears a framework in which fractional reserve banks emerge in equilibrium, where bank assets are funded with liabilities made demandable in government money, where the terms of bank deposit contracts are affected by the liquidity insurance available in financial markets, where banks are subject to runs, and where a central bank has a meaningful role to play, both in terms of inflation policy and as a lender of last resort. Among other things, the model provides a rationale for nominal deposit contracts combined with a central bank lender-of-last-resort facility to promote efficient liquidity insurance and a panic-free banking system.