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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. Grandmont, Jean-Michel, 1986. "Stabilizing competitive business cycles," Journal of Economic Theory, Elsevier, Elsevier, vol. 40(1), pages 57-76, October.
  2. James Peck & Karl Shell, 2003. "Equilibrium Bank Runs," Journal of Political Economy, University of Chicago Press, University of Chicago Press, vol. 111(1), pages 103-123, February.
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  4. 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.
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  14. Balasko, Yves & Shell, Karl, 1981. "The overlapping-generations model. II. The case of pure exchange with money," Journal of Economic Theory, Elsevier, Elsevier, vol. 24(1), pages 112-142, February.
  15. Mitsui, Toshihide & Watanabe, Shinichi, 1989. "Monetary growth in a turnpike environment," Journal of Monetary Economics, Elsevier, Elsevier, vol. 24(1), pages 123-137, July.
  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, 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, American Economic Association, vol. 77(5), pages 954-71, December.
  18. Smith, Bruce D, 1994. "Efficiency and Determinacy of Equilibrium under Inflation Targeting," Economic Theory, Springer, Springer, vol. 4(3), pages 327-44.
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