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Discount Window Policy, Banking Crises, and Indeterminacy of Equilibrium

Author

Listed:
  • Gaetano Antinolfi

    () (Department of Economics, Washington University)

  • Todd Keister

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

Abstract

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.

Suggested Citation

  • Gaetano Antinolfi & Todd Keister, 2003. "Discount Window Policy, Banking Crises, and Indeterminacy of Equilibrium," Working Papers 0305, Centro de Investigacion Economica, ITAM.
  • Handle: RePEc:cie:wpaper:0305
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    References listed on IDEAS

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    Cited by:

    1. Bhattacharya, Joydeep & Singh, Rajesh, 2006. "On the Usefulness of the Constrained Planning Problem in a Model of Money," Staff General Research Papers Archive 12660, Iowa State University, Department of Economics.
    2. Bhattacharya, Joydeep & Singh, Rajesh, 2005. "Optimal Choice of Monetary Instruments in an Economy with Real and Liquidity Shocks," Staff General Research Papers Archive 12355, Iowa State University, Department of Economics.
    3. Bhattacharya, Joydeep & Singh, Rajesh, 2008. "Optimal choice of monetary policy instruments in an economy with real and liquidity shocks," Journal of Economic Dynamics and Control, Elsevier, vol. 32(4), pages 1273-1311, April.
    4. Joseph H. Haslag & Antoine Martin, 2007. "Optimality of the Friedman Rule in an Overlapping Generations Model with Spatial Separation," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 39(7), pages 1741-1758, October.
    5. Edgar A. Ghossoub & Robert Reed, 2008. "Liquidity Risk, Economic Development, and the Effects of Monetary Policy," Working Papers 0070, College of Business, University of Texas at San Antonio.
    6. Tarishi Matsuoka & Makoto Watanabe, 2017. "Banking Panics and Liquidity in a Monetary Economy," CESifo Working Paper Series 6722, CESifo Group Munich.
    7. Machicado, Carlos Gustavo, 2008. "Liquidity shocks and the dollarization of a banking system," Journal of Macroeconomics, Elsevier, vol. 30(1), pages 369-381, March.
    8. Bhattacharya, Joydeep & Haslag, Joseph H. & Martin, Antoine, 2009. "Why does overnight liquidity cost more than intraday liquidity?," Journal of Economic Dynamics and Control, Elsevier, vol. 33(6), pages 1236-1246, June.
    9. Tarishi Matsuoka, 2011. "Temporary Bubbles and Discount Window Policy," KIER Working Papers 802, Kyoto University, Institute of Economic Research.
    10. Ennis, Huberto M., 2016. "Models of Discount Window Lending: A Review," Economic Quarterly, Federal Reserve Bank of Richmond, issue 1Q, pages 1-50.
    11. Matsuoka, Tarishi, 2012. "Imperfect interbank markets and the lender of last resort," Journal of Economic Dynamics and Control, Elsevier, vol. 36(11), pages 1673-1687.
    12. Bhattacharya, Joydeep & Singh, Rajesh, 2010. "Optimal monetary rules under persistent shocks," Journal of Economic Dynamics and Control, Elsevier, vol. 34(7), pages 1277-1294, July.
    13. Ghossoub, Edgar & Reed III, Robert R., 2010. "Liquidity risk, economic development, and the effects of monetary policy," European Economic Review, Elsevier, vol. 54(2), pages 252-268, February.
    14. Tetsuo Ono, 2018. "Fiscal Rules in a Monetary Economy: Implications for Growth and Welfare," Discussion Papers in Economics and Business 18-27, Osaka University, Graduate School of Economics and Osaka School of International Public Policy (OSIPP).
    15. Todd Keister, 2009. "Central Bank Lending and Inflation," 2009 Meeting Papers 782, Society for Economic Dynamics.
    16. Joseph H. Haslag & Joydeep Bhattacharya & Antoine Martin, 2007. "Money, output and the payment system: Optimal monetary policy in a model with hidden effort," Working Papers 0704, Department of Economics, University of Missouri.

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