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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

    (World Bank)

Abstract

We study an economy where agents are subject to liquidity demand shocks, and banks arise endogenously to insure consumers against these shocks. In this environment we evaluate the desirability of a lender of last resort who can provide liquidity loans to banks in distress. In the absence of a lender of last resort, the economy has a unique, stationary equilibrium. The introduction of unlimited and costless lender of last resort services allows the economy to achieve a steady state allocation that is pareto optimal. However, this economy also displays a continuum of hyperinflationary equilibria. We then explore restrictions on the provision of lender of last resort services that rule out such monetary instability while preserving some of the efficiency obtained by unrestricted lender of last resort services. When the lender of last resort charges an interest rate on liquidity loans, the economy has a unique steady state equilibrium, and when the interest rate charged is high enough, no hyperinflationary equilibria arise. Finally, when the lender of last resort faces an upper bound on loanable funds, there is again a unique long-run equilibrium, and when the upper bound on loanable funds is small enough, hyperinflationary equilibria are ruled out.

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Bibliographic Info

Paper provided by Econometric Society in its series Econometric Society World Congress 2000 Contributed Papers with number 1156.

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Date of creation: 01 Aug 2000
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Handle: RePEc:ecm:wc2000:1156

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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, vol. 31(3), pages 624-59, August.
  2. 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.
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  8. Stephen D. Williamson, 1995. "Discount Window Lending and Deposit Insurance," Macroeconomics 9504001, EconWPA, revised 18 Apr 1995.
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  11. Frederic S. Mishkin, 2000. "Lessons from the Asian Crisis," NBER Working Papers 7102, National Bureau of Economic Research, Inc.
  12. James Peck & Karl Shell, 2003. "Equilibrium Bank Runs," Journal of Political Economy, University of Chicago Press, vol. 111(1), pages 103-123, February.
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  15. Smith, Bruce D, 1994. "Efficiency and Determinacy of Equilibrium under Inflation Targeting," Economic Theory, Springer, vol. 4(3), pages 327-44.
  16. 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, issue Fall, pages 3-16.
  17. 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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  19. Freeman, Scott, 1999. "Rediscounting under aggregate risk," Journal of Monetary Economics, Elsevier, vol. 43(1), pages 197-216, February.
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