CREDIT POLICY IN TIMES OF FINANCIAL DISTRESS
Washington University and Federal Reserve Bank of St. Louis
This essay evaluates two central bank policy tools, capital requirements and lending of last resort, designed to avert financial panics in the context of endowment economics with complete markets and limited borrower commitment. Credit panics are self-fulfilling shocks to expected credit conditions which cause transitions from an optimal but fragile steady state to a suboptimal state with zero unsecured credit. The main findings are: (i) Countercyclical reserve policies protect the optimum equilibrium against modest shocks but are powerless against large shocks. (ii) If we ignore private information and central banks inefficiencies, this class of models bears out Bagehot’s 1873 claim in Lombard Street: panics are averted if central banks stand ready to lend at a rate somewhat above the one associated with the optimal state.
Keywords: bank panics, last resort, capital requirements, credit conditions
JEL Classification: E52, E58, E44
Acknowledgements: The views expressed in this paper are personal and do not represent any institution affiliated with the author. Thanks go to Jundong Zhang for excellent research assistance
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