This paper studies the role of a lender of last resort (LLR) in a monetary model where a shortage of bank’s monetary reserves (or a banking panic) occurs endogenously. We show that while a discount window policy introduced by the LLR is welfare improving, it reduces the banks’ ex ante incentive to hold reserves, which increases the probability of a panic, and causes moral hazard in asset investments. We also examine the combined effect of other related policies such as a penalty in lending rate, liquidity requirements, and constructive ambiguity.
# 19-002/V (2019-01-11)
- Makoto (M.) Watanabe, VU Amsterdam; Tarishi Matsuoka, Tokyo Metropolitan University
- Monetary Equilibrium, Banking Panic, Moral Hazard, Lender of Last Resort
- JEL codes: