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An introduction to the Diamond-Dybvig model (1983)



I IIINII ulu Illlh III NNI IUN I~ INN !~ NII Tilburg University I„ AN INTRODUCTION TO THE DIAMOND-DYBVIG MODEL (1983) Jan J.G. Lemmen ~~,; ~ r FEW 645 ,c Communicated by Dr. S. Eijffinger An Introduction to the Diamond-Dybvig Model (1983) by Jan J.G. Lemmen September 1993' Tilburg University Department of Economics and CentER P.O. Box 90153 NL-5000 LE Tilburg The Netherlands ' Paptr prcpared fiir the CentER Minicourse on Financial Economics, Tilburg University, The Ncthcrlands. 1 I Introduction "The present papc;r provides a non-technical introduction to Diamond and Dybvig's 1983 m~xleL The paper is organised as follows. In Section II, I explain the link between liquidity crcation atxl the hank run equilibriwn in the Diamond-Dybvig model. Furthermore. Section II emphasises the particular role of the demand deposit contract between the bank and the depositor. Section lII raises the issues of risk neutral consumers and prudential control regulation to prevent bank runs. Section IV criticises the Diamond-Dybvig model and concludes the paper. II The link between liquidity creation and the bank run equilibrium in the Diamond-Dybvig model 1'he world of Diamond and Dybvig (1983) is characterised by three periods (T-0,1,2), two types of consumers and a single homogenous good (see figure 1). Consumers in period 0 are ex ante all alike. Type I consumers are impatient and consume everything they own in period I. Type II consumers are patient and prefer to consume in period 2. A fraction p of the population are type 1 consumers and a fraction 1-p of the population are type 2 consumers. [n period 0 no consumer knows if he or she is a type I or a type II consumer in period 1. In this way the authors model the uncertainty with respect to the demand for money of the individual consumer. Figure 1- A formal representation of consumption and investment in the Diamond-Dybvig model T-0 T-1 T-2 Type I Investment Consumption Type II Investment Investment Consumption

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