4. The following is from the press announcement of the 2023 Nobel Prize in Economics: KUNGL....

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4. The following is from the press announcement of the 2023 Nobel Prize in Economics: KUNGL. VETENSKAPS AKADEMIEN THE ROYAL SMEDSH ACADEMY OF SCIENCES 10 October 2022 The Royal Swedish Academy of Sciences has decided to award the Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel 2022 to Ben S. Bernanke The Brookings Institution, Washington DC, USA Douglas W. Diamond University of Chicago, IL, USA Philip H. Dybvig Washington University in St. Louis, MO, USA "for research on banks and financial crises" For the economy to function, savings must be channelled to investments. However, there is a conflict here: savers want instant access to their money in case of unexpected outlays, while businesses and homeowners need to know they will not be forced to repay their loans prematurely. In their theory, Diamond and Dybvig show how banks offer an optimal solution to this problem. By acting as intermediaries that accept deposits from many savers, banks can allow depositors to access their money when they wish, while also offering long-term loans to borrowers. However, their analysis also showed how the combination of these two activities makes banks vulnerable to rumours about their imminent collapse. If a large number of savers simultaneously run to the bank to withdraw their money, the rumour may become a self- fulfilling prophecy - a bank run occurs and the bank collapses. These dangerous dynamics can be prevented through the government providing deposit insurance and acting as a lender of last resort to banks. (5 points) Explain how in the Diamond-Dybvig model deposit insurance can eliminate bank runs. 4. The following is from the press announcement of the 2023 Nobel Prize in Economics: KUNGL. VETENSKAPS AKADEMIEN THE ROYAL SMEDSH ACADEMY OF SCIENCES 10 October 2022 The Royal Swedish Academy of Sciences has decided to award the Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel 2022 to Ben S. Bernanke The Brookings Institution, Washington DC, USA Douglas W. Diamond University of Chicago, IL, USA Philip H. Dybvig Washington University in St. Louis, MO, USA "for research on banks and financial crises" For the economy to function, savings must be channelled to investments. However, there is a conflict here: savers want instant access to their money in case of unexpected outlays, while businesses and homeowners need to know they will not be forced to repay their loans prematurely. In their theory, Diamond and Dybvig show how banks offer an optimal solution to this problem. By acting as intermediaries that accept deposits from many savers, banks can allow depositors to access their money when they wish, while also offering long-term loans to borrowers. However, their analysis also showed how the combination of these two activities makes banks vulnerable to rumours about their imminent collapse. If a large number of savers simultaneously run to the bank to withdraw their money, the rumour may become a self- fulfilling prophecy - a bank run occurs and the bank collapses. These dangerous dynamics can be prevented through the government providing deposit insurance and acting as a lender of last resort to banks. (5 points) Explain how in the Diamond-Dybvig model deposit insurance can eliminate bank runs.

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In the DiamondDybvig model deposit insurance can eliminate bank runs by providing a guarantee to depositors that their funds will be protected even if ... View the full answer