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

Gaetano Antinolfi (), Elisabeth Huybens () and Todd Keister ()
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Elisabeth Huybens: The World Bank

No 1, Working Papers from Centro de Investigacion Economica, ITAM

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 non-optimal 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.

Pages: 36 pages
Date: 2000-08
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http://ftp.itam.mx/pub/academico/inves/keister/00-01.pdf First version, 2000 (application/pdf)

Related works:
Journal Article: Monetary Stability and Liquidity Crises: The Role of the Lender of Last Resort (2001) Downloads
Working Paper: Monetary Stability and Liquidity Crises: The Role of the Lender of Last Resort (2000) Downloads
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