Market participation in a two-sector Diamond-Dybvig economy
Studies in Economics and Finance
Article publication date: 3 October 2016
This paper aims to reconsider the role of asset-market participation in Diamond-Dybvig economies, to reconcile the existence of asset markets as a channel for financial integration with the distortions that they might impose on the banking system.
The paper is a two-sector Diamond-Dybvig model of financial intermediation, with comparative advantages in the investment technologies, and introduces the possibility for the depositors to participate in an economy-wide asset market, when they can trade a bond without being observed by their banks.
The two-sector competitive banking equilibrium with hidden trades is not equivalent to autarky, is the unique Nash equilibrium of a “participation game” and is a constrained efficient.
This paper is the first to characterize the equilibrium of a two-sector Diamond-Dybvig economy with hidden trading in the asset market, and produces novel results, in contrast to the existing literature, with respect to the rationale for the existence of a financial system, its coexistence with asset markets and its efficiency. These conclusions also have important implications in terms of policy, in particular, regarding the case for the introduction of financial regulation.
The author would like to thank the editor, and the seminar participants at Brunel University London for their helpful comments. Financial support by FCT (Fundação para a Ciência e a Tecnologia) Portugal, as part of the Project PTDC/IIM-ECO/6337/2014, is gratefully acknowledged. The analyses, opinions and findings of this paper represent the author’s own views, and are not necessarily those of Banco de Portugal or the Eurosystem.
Panetti, E. (2016), "Market participation in a two-sector Diamond-Dybvig economy", Studies in Economics and Finance, Vol. 33 No. 4, pp. 660-678. https://doi.org/10.1108/SEF-06-2015-0160
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