Deflation Caused by Bank Insolvency

The Japanese economy has suffered from persistent deflation since the mid-1990s, when the banking system fell into serious undercapitalization. In Germany and in China, worries about impending deflation have emerged, along with fear of prospective or hidden bank insolvency.

In this paper I present a simple model in which bank insolvency causes deflation. During a period of bank insolvency, bank deposits in excess of bank assets continue to exist if the government (implicitly) guarantees them. I assume that bank deposits cannot exceed a certain multiple of the monetary base and that the government is prohibited to expand fiscal expenditures. A government that guarantees unbacked bank deposits without recapitalizing an insolvent banking system is forced to set the nominal interest rate at zero and to let the price level fall.