Monetary stability and liquidity crises: The role of the lender of last resort

We evaluate the desirability of having an elastic currency generated by a l ender of last resort that prints money and lends it to banks in distress. W hen banks cannot borrow, the economy has a unique equilibrium that is not P areto optimal. The introduction of unlimited borrowing at a zero nominal in terest rate generates a steady state equilibrium that is Pareto optimal. Ho wever, this policy is destabilizing in the sense that it also introduces a continuum of nonoptimal inflationary equilibria. We explore two alternate p olicies 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 eq uilibria can arise. For some (but not all) economies, the unique equilibriu m under this policy is Pareto optimal. If the lender of last resort instead charges a zero real interest rate, no inflationary equilibria can arise. T he unique equilibrium in this case is always Pareto optimal. (C) 2001 Acade mic Press.