We study an economy where agents are subject to liquidity demand shocks, and banks arise endogenously to insure consumers against these shocks. In this environment we evaluate the desirability of a lender of last resort who can provide liquidity loans to banks in distress. In the absence of a lender of last resort, the economy has a unique, stationary equilibrium. The introduction of unlimited and costless lender of last resort services allows the economy to achieve a steady state allocation that is pareto optimal. However, this economy also displays a continuum of hyperin ‡ationary equilibria. We then explore restrictions on the provision of lender of last resort services that rule out such monetary instability while preserving some of the e¢ciency obtained by unrestricted lender of last resort services. When the lender of last resort charges an interest rate on liquidity loans, the economy has a unique steady state equilibrium, and when the interest rate charged is high enough, no hyperin ‡ationary equilibria arise. Finally, when the lender of last resort faces an upper bound on loanable funds, there is again a unique long-run equilibrium, and when the upper bound on loanable funds is small enough, hyperin ‡ationary equilibria are ruled out. ¤We thank seminar participants at UCSB and at the 2000 Winter Camp in International Economics and Finance, Paracas, Peru, for helpful comments. We especially thank Bruce Smith for encouraging this line of research and for extremely helpful discussions. All errors are our own.

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.

Can monetary policy guide expectations toward desirable outcomes when equilibrium and welfare are sensitive to alternative, commonly held rational beliefs? This paper studies this question in an exchange economy with endogenous debt limits in which dynamic complementarities between dated debt limits support two Pareto-ranked steady states: a suboptimal, locally stable autarkic state and a constrained optimal, locally unstable trading state. The authors identify feedback policies that reverse the stability properties of the two steady states and ensure rapid convergence to the constrained optimal state. (JEL E31, E42, E58)

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