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Monetary Stability and Liquidity Crises: The Role of the Lender of Last Resort

  • Gaetano Antinolfi

    ()

    (Washington University)

  • Elisabeth Huybens

    ()

    (The World Bank)

  • Todd Keister

    ()

    (Centro de Investigacion Economica (CIE), Instituto Tecnologico Autonomo de Mexico (ITAM))

We evaluate the desirability of having an elastic currency generated by a lender of last resort that prints money and lends it to banks in distress. When banks cannot borrow, the economy has a unique equilibrium that is not Pareto optimal. The introduction of unlimited borrowing at a zero nominal interest rate generates a steady state equilibrium that is Pareto optimal. However, this policy is destabilizing in the sense that it also introduces a continuum of non-optimal inflationary equilibria. We explore two alternate policies aimed at eliminating such monetary instability while preserving the steady-state benefits of an elastic currency. If the lender of last resort imposes an upper bound on borrowing that is low enough, no inflationary equilibria can arise. For some (but not all) economies, the unique equilibrium under this policy is Pareto optimal. If the lender of last resort instead charges a zero real interest rate, no inflationary equilibria can arise. The unique equilibrium in this case is always Pareto optimal.

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File URL: http://ftp.itam.mx/pub/academico/inves/keister/00-01.pdf
File Function: First version, 2000
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Paper provided by Centro de Investigacion Economica, ITAM in its series Working Papers with number 0001.

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Length: 36 pages
Date of creation: Aug 2000
Date of revision:
Handle: RePEc:cie:wpaper:0001
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  1. Williamson, S.D., 1995. "Discount Window Lending and Deposit Insurance," Working Papers 95-01, University of Iowa, Department of Economics.
  2. Smith, Bruce D, 1994. "Efficiency and Determinacy of Equilibrium under Inflation Targeting," Economic Theory, Springer, vol. 4(3), pages 327-44.
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  9. 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.
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  15. 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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