Markets and Banks: A Note on Diamond and Dybvig Model of Banking

Abstract

This paper points out that in the well-known Diamond-Dybvig (1983) model of banking, the full information social optimum cannot be implemented by deposit contracts once trading among agents is allowed. The paper is in stark contrast to Jacklin (1987), which shows that equity trading dominates the banking arrangement. By pointing out the flaw in Jacklins analysis, we show that neither the banking arrangement nor the equity trading can improve upon the autarky allocation. The ability of the banking system to create liquidity is shown to depend on the possibility of trades among agents.