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Monetary Stability and Liquidity Crises: The Role of the Lender of Last Resort

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  • Gaetano Antinolfi

    ()
    (Washington University)

  • Elisabeth Huybens

    ()
    (The World Bank)

  • Todd Keister

    ()
    (Centro de Investigacion Economica (CIE), Instituto Tecnologico Autonomo de Mexico (ITAM))

Abstract

We evaluate the desirability of having an elastic currency generated by a lender of last resort that prints money and lends it to banks in distress. When banks cannot borrow, the economy has a unique equilibrium that is not Pareto optimal. The introduction of unlimited borrowing at a zero nominal interest rate generates a steady state equilibrium that is Pareto optimal. However, this policy is destabilizing in the sense that it also introduces a continuum of non-optimal inflationary equilibria. We explore two alternate policies aimed at eliminating such monetary instability while preserving the steady-state benefits of an elastic currency. If the lender of last resort imposes an upper bound on borrowing that is low enough, no inflationary equilibria can arise. For some (but not all) economies, the unique equilibrium under this policy is Pareto optimal. If the lender of last resort instead charges a zero real interest rate, no inflationary equilibria can arise. The unique equilibrium in this case is always Pareto optimal.

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File URL: http://ftp.itam.mx/pub/academico/inves/keister/00-01.pdf
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Bibliographic Info

Paper provided by Centro de Investigacion Economica, ITAM in its series Working Papers with number 0001.

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Length: 36 pages
Date of creation: Aug 2000
Date of revision:
Handle: RePEc:cie:wpaper:0001

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  1. Smith, Bruce D & Weber, Warren E, 1999. "Private Money Creation and the Suffolk Banking System," Journal of Money, Credit and Banking, Blackwell Publishing, Blackwell Publishing, vol. 31(3), pages 624-59, August.
  2. Williamson, S.D., 1995. "Discount Window Lending and Deposit Insurance," Working Papers, University of Iowa, Department of Economics 95-01, University of Iowa, Department of Economics.
  3. Mishkin, Frederic S., 1999. "Lessons from the Asian crisis," Journal of International Money and Finance, Elsevier, vol. 18(4), pages 709-723, August.
  4. Gale, David, 1973. "Pure exchange equilibrium of dynamic economic models," Journal of Economic Theory, Elsevier, vol. 6(1), pages 12-36, February.
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  7. Roberto Chang & Andres Velasco, 1998. "Financial Fragility and the Exchange Rate Regime," NBER Working Papers 6469, National Bureau of Economic Research, Inc.
  8. Sargent, Thomas J & Wallace, Neil, 1982. "The Real-Bills Doctrine versus the Quantity Theory: A Reconsideration," Journal of Political Economy, University of Chicago Press, University of Chicago Press, vol. 90(6), pages 1212-36, December.
  9. Balasko, Yves & Shell, Karl, 1981. "The overlapping-generations model. II. The case of pure exchange with money," Journal of Economic Theory, Elsevier, vol. 24(1), pages 112-142, February.
  10. Stanley Fischer, 1999. "On the Need for an International Lender of Last Resort," Journal of Economic Perspectives, American Economic Association, vol. 13(4), pages 85-104, Fall.
  11. Mitsui, Toshihide & Watanabe, Shinichi, 1989. "Monetary growth in a turnpike environment," Journal of Monetary Economics, Elsevier, vol. 24(1), pages 123-137, July.
  12. Champ, B. & Snith, B.D. & Williamson, D.S., 1991. "Currency Elasticity and Banking Panics: Theory and Evidence," RCER Working Papers 292, University of Rochester - Center for Economic Research (RCER).
  13. Balasko, Yves & Shell, Karl, 1980. "The overlapping-generations model, I: The case of pure exchange without money," Journal of Economic Theory, Elsevier, vol. 23(3), pages 281-306, December.
  14. Neil Wallace, 1988. "Another attempt to explain an illiquid banking system: the Diamond and Dybvig model with sequential service taken seriously," Quarterly Review, Federal Reserve Bank of Minneapolis, Federal Reserve Bank of Minneapolis, issue Fall, pages 3-16.
  15. Freeman, Scott, 1999. "Rediscounting under aggregate risk," Journal of Monetary Economics, Elsevier, vol. 43(1), pages 197-216, February.
  16. Woodford, Michael, 1986. "Stationary sunspot equilibria in a finance constrained economy," Journal of Economic Theory, Elsevier, vol. 40(1), pages 128-137, October.
  17. Smith, Bruce D, 1994. "Efficiency and Determinacy of Equilibrium under Inflation Targeting," Economic Theory, Springer, vol. 4(3), pages 327-44.
  18. Hornstein, Andreas & Krusell, Per, 1993. "Money and Insurance in a Turnpike Environment," Economic Theory, Springer, vol. 3(1), pages 19-34, January.
  19. Townsend, Robert M, 1987. "Economic Organization with Limited Communication," American Economic Review, American Economic Association, vol. 77(5), pages 954-71, December.
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