Interest rate and bank rescue policy

This paper presents a model in which the policy rate set by the central bank affects decisions about bank rescue policies when liquidity crises hit the banking system. We highlight a trade-off: maintaining an interest rate ensuring effective control over inflation escalates the costs of rescue interventions. We delve into this trade-off and determine the circumstances under which deviating from the target interest rate, thereby reducing intervention costs, enhances overall welfare. From a normative standpoint, our analysis indicates where liquidity risk is either low or high, the central bank should prioritize achieving the inflation target.