Banks and Liquidity Creation: A Simple Exposition of the Diamond-Dybvig Model

Abstract

This article uses narrative and numerical examples to exposit the ideas in Diamond and Dybvig (1983) and some recent extensions of their model. Banks create demand deposits to provide investors with liquid assets. Demand deposits work very well when investors forecast that banks will survive, but bank runs can cause severe damage if investors lose faith in banks. There is scope for banks to write more refined contracts, such as deposits with suspension of convertibility of deposits to cash. In addition, there may be a role for government policies that eliminate self-fulfilling runs on banks.