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

Gaetano Antinolfi, Elisabeth Huybens, Todd Keister

Research output: Contribution to journalArticlepeer-review

18 Scopus citations

Abstract

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 nonoptimal 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. Journal of Economic Literature Classification Numbers: E31, E42, E58, G21.

Original languageAmerican English
Pages (from-to)187-219
Number of pages33
JournalJournal of Economic Theory
Volume99
Issue number1-2
DOIs
StatePublished - Jul 2001
Externally publishedYes

ASJC Scopus subject areas

  • Economics and Econometrics

Keywords

  • Banking crises
  • Discount window policy
  • Elastic currency
  • Inflation
  • Lender of last resort
  • Liquidity crises
  • Multiple equilibria

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