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Discount Window Policy, Banking Crises, and Indeterminacy of Equilibrium

  • Gaetano Antinolfi


    (Department of Economics, Washington University)

  • Todd Keister


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

We examine optimal discount window policy in an economy with a linear investment technology and aggregate liquidity shocks. Unrestricted lending at the discount window prevents large shocks from causing banking crises, but leads to indeterminacy of stationary equilibrium. We show how a policy of offering discount-window loans at an above-market interest rate generates a unique stationary monetary equilibrium. Under such a policy, banking crises occur with positive probability in equilibrium, but a proper choice of interest rate can make the welfare loss due to these crises arbitrarily small. We then modify the model by introducing diminishing returns to investment and show that, in this case, the optimal policy may eliminate banking crises entirely.

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Paper provided by Centro de Investigacion Economica, ITAM in its series Working Papers with number 0305.

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Length: 29 pages
Date of creation: Jun 2003
Date of revision:
Handle: RePEc:cie:wpaper:0305
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  1. Ennis, Huberto M. & Keister, Todd, 2003. "Economic growth, liquidity, and bank runs," Journal of Economic Theory, Elsevier, vol. 109(2), pages 220-245, April.
  2. Stephen D. Williamson, 1998. "Discount Window Lending and Deposit Insurance," Review of Economic Dynamics, Elsevier for the Society for Economic Dynamics, vol. 1(1), pages 246-275, January.
  3. Champ, B. & Smith, B.D., 1991. "Currency Elasticity and Banking Panics: theory and Evidence," University of Western Ontario, The Centre for the Study of International Economic Relations Working Papers 9109, University of Western Ontario, The Centre for the Study of International Economic Relations.
  4. Diamond, Douglas W & Dybvig, Philip H, 1983. "Bank Runs, Deposit Insurance, and Liquidity," Journal of Political Economy, University of Chicago Press, vol. 91(3), pages 401-19, June.
  5. Freeman, Scott, 1996. "The Payments System, Liquidity, and Rediscounting," American Economic Review, American Economic Association, vol. 86(5), pages 1126-38, December.
  6. Freeman, Scott, 1999. "Rediscounting under aggregate risk," Journal of Monetary Economics, Elsevier, vol. 43(1), pages 197-216, February.
  7. John H. Boyd & Pedro Gomis & Sungkyu Kwak & Bruce D. Smith, 2000. "A User's Guide to Banking Crises," Monash Economics Working Papers archive-36, Monash University, Department of Economics.
  8. Stacey L. Schreft & Bruce D. Smith, 2002. "The conduct of monetary policy with a shrinking stock of government debt," Proceedings, Federal Reserve Bank of Cleveland, pages 848-886.
  9. Townsend, Robert M, 1987. "Economic Organization with Limited Communication," American Economic Review, American Economic Association, vol. 77(5), pages 954-71, December.
  10. Antinolfi, Gaetano & Huybens, Elisabeth & Keister, Todd, 2001. "Monetary Stability and Liquidity Crises: The Role of the Lender of Last Resort," Journal of Economic Theory, Elsevier, vol. 99(1-2), pages 187-219, July.
  11. James Peck & Karl Shell, 2003. "Equilibrium Bank Runs," Journal of Political Economy, University of Chicago Press, vol. 111(1), pages 103-123, February.
  12. Sargent, Thomas J & Wallace, Neil, 1982. "The Real-Bills Doctrine versus the Quantity Theory: A Reconsideration," Journal of Political Economy, University of Chicago Press, vol. 90(6), pages 1212-36, December.
  13. Bruce D. Smith, 2002. "Monetary Policy, Banking Crises, and the Friedman Rule," American Economic Review, American Economic Association, vol. 92(2), pages 128-134, May.
  14. Gale, David, 1973. "Pure exchange equilibrium of dynamic economic models," Journal of Economic Theory, Elsevier, vol. 6(1), pages 12-36, February.
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