"Summary of Recommendations: . . . Repeal present control by the System over interest rates that member banks may pay on time deposits and present prohibition of interest payments by member banks on demand deposits." Milton Friedman (1960, p. 100) "I conclude that the over-all monetary effects of ceiling regulations are small and easy to neutralize by traditional monetary controls. The allocative and distributive effects are, however, unfortunate. The root of the policy was an exaggerated and largely unnecessary concern for the technical solvency of savings and loan associations." James Tobin (1970, p. 5) The regulation of deposit interest rates has received little support from economists. The same is true for the original rationale for such regulation: that bank competition for deposits generates inherent "instability" in the banking system. This paper develops an "adverse selection" model of banking in which this rationale is correct. Moreover, in this model instability in the banking system can arise despite the presence of a "lender of last resort," and despite the absence of any need for "deposit insurance." However, in the world described, the regulation of deposit interest rates is shown to be an appropriate response to "instability" in the banking system. Finally, it is argued that "adverse selection" models of deposit interest rate determination can confront a number of observed phenomena that are not readily explained in other contexts.

Recent developments in the theory of economies with private information permit a re-examination of the issues raised in the "real bills-quantity theory" debate. A model is developed here in which there are banks, in which fiat money is present, and in which agents possess private information. Two regulatory regimes are then considered. In the first, banks are essentially unregulated. In the second, banks face 100 percent reserve requirements. Issues related to existence and optimality of equilibrium are addressed, and problems with existence are given an interpretation in terms of the "stability" of the banking system. Existence (stability) problems which arise under laissez-faire banking can be rectified by a 100 percent reserve requirement. However, unless there is private information regarding access to investment opportunities, there are typically better ways to accomplish this. Finally, it is shown that even in the presence of 100 percent reserve requirements banks are not simply "money warehouses." Bank deposits and money bear different (real) return streams, even under 100 percent reserves.

"Financial intermediary-coalitions" (WP 272) replaces "Financial intermediaries" (WP 231) and "Father of financial intermediary-coalitions" (WP 250).

"Financial intermediary-coalitions" (WP 272) replaces "Financial intermediaries" (WP 231) and "Father of financial intermediary-coalitions" (WP 250).

"Financial intermediary-coalitions" (WP 272) replaces "Financial intermediaries" (WP 231) and "Father of financial intermediary-coalitions" (WP 250).

In a finite-trader version of the Diamond-Dybvig (1983) model, the symmetric, ex-ante efficient allocation is implementable by a direct mechanism (i.e., each trader announces the type of his own ex-post preference) in which truthful revelation is the strictly dominant strategy for each trader. When the model is modified by formalizing the sequential-service constraint (cf. Wallace, 1988), the truth-telling equilibrium implements the symmetric, ex-ante efficient allocation with respect to iterated elimination of strictly dominated strategies.