Banking and Inside Money: Revisiting the Efficiency of Deposit Contracts

Abstract

In this paper we show that nominal demand deposits are not, in general, Pareto optimal contracts. We construct a variation of the Diamond-Dybvig model where bank intermediation is done through inside money. In this setting, we show that the interplay between non-contingent deposit contracts and price flexibility is not a sufficient mechanism to provide efficient risk-sharing. Furthermore, state-contingent deposit contracts do not expand the consumption possibility set to include the efficient allocation and could even be inferior to other market arrangements. Finally, we discuss the extent to which central banks can improve the banking allocation through their monetary policy and regulation.