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Working Paper

On the Non-Optimality of a Diamond-Dybvig Contract in the Goldstein-Pauzner Environment

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I show, under intuitive conditions on the risk-averse utility function, the nonoptimality of the Diamond and Dybvig (1983) contract in the Goldstein and Pauzner (2005) environment. If marginal utility at zero is low enough, then Goldstein and Pauzner (2005)’s claim about the optimality of the Diamond and Dybvig (1983) contract is true. When it is not, the optimal contract insures the patient depositor against a project default. The contract may exhibit risk-sharing with the impatient depositor. Unlike when Goldstein and Pauzner (2005)’s claim is correct, relative risk aversion greater than 1 does not necessarily make the optimal bank contract run-prone. I present a condition under which it is.
Topics
Econometrics, modeling, and forecasting
04.30.2013ISSN 2573-7953 WP 13-06DOI 10.26509/frbc-wp-201306
Keywords bank runs
JEL Classification Codes D86, G21

Working Papers of the Federal Reserve Bank of Cleveland are preliminary materials circulated to stimulate discussion and critical comment on research in progress. They may not have been subject to the formal editorial review accorded official Federal Reserve Bank of Cleveland publications. The views expressed in this paper are those of the authors and do not represent the views of the Federal Reserve Bank of Cleveland or the Federal Reserve System.

Suggested Citation

Elamin, Mahmoud. 2013. “On the Non-Optimality of a Diamond-Dybvig Contract in the Goldstein-Pauzner Environment .” Federal Reserve Bank of Cleveland, Working Paper No. 13-06. https://doi.org/10.26509/frbc-wp-201306