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Money under the mattress: Inflation and lending of last resort

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Listed:
  • Barlevy, Gadi
  • Bird, Daniel
  • Fershtman, Daniel
  • Weiss, David

Abstract

This paper examines whether the two key functions of central banks—ensuring price stability and lending during crises—necessarily conflict. We develop a nominal model of bank runs à la Diamond and Dybvig (1983) in which individuals can store the money they withdraw “under the mattress.” In this setting, lending of last resort need not be inflationary. Whether it is depends on the interest rates the central bank charges on its loans. Our results suggest that the central bank must not charge a rate that is too low if it wants to ensure price stability, and must charge a high rate if it wants to robustly attain the ex-ante efficient outcome. These rationales for charging high interest rates on loans during a crisis are distinct from the arguments Bagehot originally relied on to advocate for a similar rule.

Suggested Citation

  • Barlevy, Gadi & Bird, Daniel & Fershtman, Daniel & Weiss, David, 2024. "Money under the mattress: Inflation and lending of last resort," Journal of Economic Theory, Elsevier, vol. 217(C).
    • Handle: RePEc:eee:jetheo:v:217:y:2024:i:c:s0022053124000103
    DOI: 10.1016/j.jet.2024.105804
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    References listed on IDEAS

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    More about this item

    Keywords

    Bagehot rule; Bank runs; Financial stability; Price-level stability;
    All these keywords.

    JEL classification:

    • E31 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles - - - Price Level; Inflation; Deflation
    • E50 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - General
    • G01 - Financial Economics - - General - - - Financial Crises

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