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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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File URL: http://ftp.itam.mx/pub/academico/inves/keister/03-05.pdf
File Function: First version, 2003
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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. Townsend, Robert M, 1987. "Economic Organization with Limited Communication," American Economic Review, American Economic Association, vol. 77(5), pages 954-71, December.
  2. Bruce Champ & Bruce D. Smith & Stephen D. Williamson, 1996. "Currency Elasticity and Banking Panics: Theory and Evidence," Canadian Journal of Economics, Canadian Economics Association, vol. 29(4), pages 828-64, November.
  3. 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.
  4. Peck, James & Shell, Karl, 2001. "Equilibrium Bank Runs," Working Papers 01-10r, Cornell University, Center for Analytic Economics.
  5. Gaetano Antinolfi & Elisabeth Huybens & Todd Keister, 2000. "Monetary Stability and Liquidity Crises: The Role of the Lender of Last Resort," Working Papers 0001, Centro de Investigacion Economica, ITAM.
  6. Williamson, S.D., 1995. "Discount Window Lending and Deposit Insurance," Working Papers 95-01, University of Iowa, Department of Economics.
  7. 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.
  8. 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.
  9. Ennis, Huberto M. & Keister, Todd, 2003. "Economic growth, liquidity, and bank runs," Journal of Economic Theory, Elsevier, vol. 109(2), pages 220-245, April.
  10. 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.
  11. John H. Boyd & Pedro Gomis-Porqueras & Sungkyu Kwak & Bruce David Smith, 2014. "A User's Guide to Banking Crises," Annals of Economics and Finance, Society for AEF, vol. 15(2), pages 800-892, November.
  12. Freeman, Scott, 1999. "Rediscounting under aggregate risk," Journal of Monetary Economics, Elsevier, vol. 43(1), pages 197-216, February.
  13. Gale, David, 1973. "Pure exchange equilibrium of dynamic economic models," Journal of Economic Theory, Elsevier, vol. 6(1), pages 12-36, February.
  14. Freeman, Scott, 1996. "The Payments System, Liquidity, and Rediscounting," American Economic Review, American Economic Association, vol. 86(5), pages 1126-38, December.
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