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DISCOUNT WINDOW POLICY, BANKING CRISES, AND INDETERMINACY OF EQUILIBRIUM

Gaetano Antinolfi () and Todd Keister ()

Macroeconomic Dynamics, 2006, vol. 10, issue 1, 1-19

Abstract: We study how discount window policy affects the frequency of banking crises, the level of investment, and the scope for indeterminacy of equilibrium. Previous work has shown that providing costless liquidity through a discount window has mixed effects in terms of these criteria: It prevents episodes of high liquidity demand from causing crises but can lead to indeterminacy of stationary equilibrium and to inefficiently low levels of investment. We show how offering discount window loans at an above-market interest rate can be unambiguously beneficial. Such a policy generates a unique stationary equilibrium. Banking crises occur with positive probability in this equilibrium and the level of investment is suboptimal, but a proper combination of discount window and monetary policies can make the welfare effects of these inefficiencies arbitrarily small. The near-optimal policies can be viewed as approximately implementing the Friedman rule.

Date: 2006
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Working Paper: Discount Window Policy, Banking Crises, and Indeterminacy of Equilibrium (2003) Downloads
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