Oxford Economic Papers Advance Access originally published online on May 27, 2004
Oxford Economic Papers 56 (2004), 513-538
© Oxford University Press 2004; All rights reserved
Financial instability, oligopolistic banking, and monetary growth
University of Paderborn, Department of Economics, 33095 Paderborn, Germany; e-mail: jungblut{at}notes.uni-paderborn.de
This paper analyzes the dynamics of a monetary economy which is characterized by increasing returns to scale in financial intermediation. The intermediation technology is linear in deposits, but its operation requires a fixed verification cost to overcome the asymmetric information about a borrower's investment outcome. Intermediaries, termed banks, can avoid the costly duplication of information disclosure. Due to the non–convexity in intermediation activities, two stationary monetary equilibria exist. The first is a saddle with high economic activity and high competition in banking. In the second equilibrium, competition between banks and economic activity are low. Under adverse economic conditions, the low activity equilibrium can bifurcate into a sink and the economy may experience periods of financial instability and banking crises. Although crises are random events, the economy's exposure to financial instabilities depends on fundamental conditions. Thus, the predictive power of fundamentals does not contradict the random theory of crises.