The Economics Book

319

less than they invested. These
investments, which are made for
a set period, are what is known
as “illiquid” investments. This
means that they cannot easily be
transformed into ready cash, as
liquid assets can.

Patient and impatient
Diamond and Dybvig assume
there are two types of people:
patient people, who want to wait
until Wednesday, when they can
consume more, and impatient
people, who want to consume on
Tuesday. However, people do not
discover which type of person they
are until Tuesday. The decision
that people face on Monday is how
much to store and how much to
invest. The only uncertainty in
the model is whether these people
are patient or impatient. Banks
might have a good idea about
probabilities: in general, 30 percent
of people might prove to be
impatient and 70 percent patient.
So it is possible that people will
store and invest amounts that

reflect these proportions. But

whatever people choose, it will

never be the most efficient outcome

overall because impatient people

should never invest, and patient

people should not store anything.

A bank can solve this problem. We

can think of a bank in this model

as a place where people all agree

to pool their goods and share risks.

The bank gives people a deposit

contract and then itself invests

and stores the goods in bulk.

The deposit contract offers a

higher return than storage and

a lower return than investment,

and allows people to withdraw

their goods from the bank on either

Tuesday or Wednesday with no

penalty. Having pooled people’s

goods, the bank, knowing the share

of patient and impatient people,

can then store enough of the good

to cover the needs of impatient

people and invest enough to cover

the wants of patient people. In the

Diamond–Dybvig model this is

a more efficient solution than

people could reach independently

because with large numbers, the

bank can do this in a way that

the individual cannot.

On Tuesday the bank has

illiquid assets—the patient people’s

investment that will reap a return

on Wednesday. At the same time

it has to pay the impatient people

their deposits right away. Its

ability to do this is the reason

for its existence. ❯❯

See also: Financial services 26–29 ■ Institutions in economics 206–07 ■ Market information and incentives 208–09 ■
Speculation and currency devaluation 288–93 ■ Financial crises 296–301

CONTEMPORARY ECONOMICS

A bank run in our

model is caused by a

shift in expectations,

which could depend

on almost anything.

Douglas Diamond

Philip Dybvig

Banks only keep a relatively small percentage of their

deposits in cash reserves. If all a bank’s depositors turn

up to demand their money back on the same day, only

those at the front of the line will receive their money.

Total depositors

Amount held in cash deposit

Bank Total amount on deposit