Economic growth, liquidity, and bank runs

Abstract

We examine the growth implications of bank runs. To do so, we construct an endogenous growth model in which bank runs occur with positive probability in equilibrium. In this setting, a bank run has a permanent effect on the capital stock and on the level of output. In addition, the possibility of a bank run changes the portfolio choice of banks and thereby affects the long-run growth rate. We consider two different equilibrium selection rules. In the first, a run is triggered by sunspots and occurs with a fixed probability. A higher probability of a run in this case leads banks to hold a more liquid portfolio, which decreases total investment and thereby reduces capital formation. Hence the economy grows slower, even when a run does not occur. Under the second selection rule, the probability of a run is influenced by the bank's portfolio choice. This leads banks to place more resources in long-term investment, and the economy both grows faster and experiences fewer runs.