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Discount Window Policy, Banking Crises, And Indeterminacy Of Equilibrium

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Author Info
ANTINOLFI, GAETANO
KEISTER, TODD

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Abstract

We study how discount window policy affects the frequency of banking crises, the level of investment, and the scope for indeterminacy of equilibrium. Previous work has shown that providing costless liquidity through a discount window has mixed effects in terms of these criteria: It prevents episodes of high liquidity demand from causing crises but can lead to indeterminacy of stationary equilibrium and to inefficiently low levels of investment. We show how offering discount window loans at an above-market interest rate can be unambiguously beneficial. Such a policy generates a unique stationary equilibrium. Banking crises occur with positive probability in this equilibrium and the level of investment is suboptimal, but a proper combination of discount window and monetary policies can make the welfare effects of these inefficiencies arbitrarily small. The near-optimal policies can be viewed as approximately implementing the Friedman rule.

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Publisher Info
Article provided by Cambridge University Press in its journal Macroeconomic Dynamics.

Volume (Year): 10 (2006)
Issue (Month): 01 (February)
Pages: 1-19
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Handle: RePEc:cup:macdyn:v:10:y:2006:i:01:p:1-19_05

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References listed on IDEAS
Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.:
  1. Sargent, Thomas J & Wallace, Neil, 1982. "The Real-Bills Doctrine versus the Quantity Theory: A Reconsideration," Journal of Political Economy, University of Chicago Press, vol. 90(6), pages 1212-36, December. [Downloadable!] (restricted)
  2. Bruce D. Smith, 2002. "Monetary Policy, Banking Crises, and the Friedman Rule," American Economic Review, American Economic Association, vol. 92(2), pages 128-134, May. [Downloadable!]
  3. Stacey L. Schreft & Bruce D. Smith, 2002. "The conduct of monetary policy with a shrinking stock of government debt," Proceedings, Federal Reserve Bank of Cleveland, pages 848-886.
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  4. Bruce Champ & Bruce D. Smith & Stephen D. Williamson, 1996. "Currency Elasticity and Banking Panics: Theory and Evidence," Canadian Journal of Economics, Canadian Economics Association, vol. 29(4), pages 828-64, November. [Downloadable!] (restricted)
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  5. Ennis, Huberto M. & Keister, Todd, 2003. "Economic growth, liquidity, and bank runs," Journal of Economic Theory, Elsevier, vol. 109(2), pages 220-245, April. [Downloadable!] (restricted)
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  6. Townsend, Robert M, 1987. "Economic Organization with Limited Communication," American Economic Review, American Economic Association, vol. 77(5), pages 954-71, December. [Downloadable!] (restricted)
  7. Freeman, Scott, 1999. "Rediscounting under aggregate risk," Journal of Monetary Economics, Elsevier, vol. 43(1), pages 197-216, February. [Downloadable!] (restricted)
  8. Freeman, Scott, 1996. "The Payments System, Liquidity, and Rediscounting," American Economic Review, American Economic Association, vol. 86(5), pages 1126-38, December. [Downloadable!] (restricted)
  9. Antinolfi, Gaetano & Huybens, Elisabeth & Keister, Todd, 2001. "Monetary Stability and Liquidity Crises: The Role of the Lender of Last Resort," Journal of Economic Theory, Elsevier, vol. 99(1-2), pages 187-219, July. [Downloadable!] (restricted)
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  10. Stephen D. Williamson, 1998. "Discount Window Lending and Deposit Insurance," Review of Economic Dynamics, Elsevier for the Society for Economic Dynamics, vol. 1(1), pages 246-275, January. [Downloadable!] (restricted)
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  11. Douglas W. Diamond & Philip H. Dybvig, 2000. "Bank runs, deposit insurance, and liquidity," Quarterly Review, Federal Reserve Bank of Minneapolis, issue Win, pages 14-23. [Downloadable!]
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  12. James Peck & Karl Shell, 2003. "Equilibrium Bank Runs," Journal of Political Economy, University of Chicago Press, vol. 111(1), pages 103-123, February. [Downloadable!] (restricted)
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  13. Gale, David, 1973. "Pure exchange equilibrium of dynamic economic models," Journal of Economic Theory, Elsevier, vol. 6(1), pages 12-36, February. [Downloadable!] (restricted)
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Cited by:
(explanations, Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.)

  1. Bhattacharya, Joydeep & Singh, Rajesh, 2006. "On the Usefulness of the Constrained Planning Problem in a Model of Money," Staff General Research Papers 12660, Iowa State University, Department of Economics. [Downloadable!]
  2. Joydeep Bhattacharya & Joseph H. Haslag & Antoine Martin, 2007. "Why does overnight liquidity cost more than intraday liquidity?," Staff Reports 281, Federal Reserve Bank of New York. [Downloadable!]
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  3. Bhattacharya, Joydeep & Singh, Rajesh, 2005. "Optimal Choice of Monetary Instruments in an Economy with Real and Liquidity Shocks," Staff General Research Papers 12355, Iowa State University, Department of Economics. [Downloadable!]
  4. Joseph H. Haslag & Antoine Martin, 2005. "Optimality of the Friedman rule in an overlapping generations model with spatial separation," Staff Reports 225, Federal Reserve Bank of New York. [Downloadable!]
    Other versions:
  5. Joseph H. Haslag & Joydeep Bhattacharya & Antoine Martin, 2007. "Money, output and the payment system: Optimal monetary policy in a model with hidden effort," Working Papers 0704, Department of Economics, University of Missouri. [Downloadable!]
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