We analyze financial collapses, such as the one that occurred during the U.S. Great Depression, from the perspective of a monetary model with multiple equilibria. The multiplicity arises from the presence of a strategic complementarity due to increasing returns to scale in the intermediation process.
Intermediaries provide the link between savers and firms who require working capital for production.
Fluctuations in the intermediation process are driven by variations in the confidence agents place in the financial system. Further, we show how adding liquidity to the banking system through increases in the money supply is sufficient to overcome strategic uncertainty and thus avoid financial collapse.