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Can a Lender of Last Resort Stabilize Financial Markets? Lessons from the Founding of the Fed

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Author Info
Asaf Bernstein
Eric Hughson
Marc D. Weidenmier

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Abstract

We use the founding of the Federal Reserve as a historical experiment to provide some insight into whether a lender of last resort can stabilize financial markets. Following the Panic of 1907, Congress passed two measures that established a lender of last resort in the United States: (1) the Aldrich-Vreeland Act of 1908 which authorized certain banks to issue emergency currency during a financial crisis and (2) the Federal Reserve Act of 1913 which established a central bank. We employ a new identification strategy to isolate the effects of the introduction of a lender of last resort from other macroeconomic shocks. We compare the standard deviation of stock returns and short-term interest rates over time across the months of September and October, the two months of the year when financial markets were most vulnerable to a crash because of financial stringency from the harvest season, with the rest of the year during the period 1870-1925. Stock volatility in the post-1907 period (June 1908-1925) was more than 40 percent lower in the months of September and October compared to the period (1870- May 1908). We also find that the volatility of the call loan rate declined nearly 70 percent in September and October following the monetary regime change.

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Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 14422.

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Date of creation: Oct 2008
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Handle: RePEc:nbr:nberwo:14422

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E4 - Macroeconomics and Monetary Economics - - Money and Interest Rates
G1 - Financial Economics - - General Financial Markets
N11 - Economic History - - Macroeconomics and Monetary Economics; Growth and Fluctuations - - - U.S.; Canada: Pre-1913
N12 - Economic History - - Macroeconomics and Monetary Economics; Growth and Fluctuations - - - U.S.; Canada: 1913-

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