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lender of last resort

lender of last resort - READING 11 Financial Fragility and...

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1 Financial Fragility and the Lender of Last Resort Desiree Schaan & Timothy Cogley Financial crises, such as banking panics and stock market crashes, were a common occurrence in the U.S. economy before World War II. Since then, financial crises have been less common. However, events of the past decade have led to renewed concerns about financial instability and about the proper role of monetary policy in reacting to financial turbulence. This Weekly Letter provides some background on the nature of financial crises, and it discusses whether and how policymakers should intervene. Our discussion borrows heavily from papers by Frederic Mishkin (1991, 1994). Because there are costs to inappropriate intervention, Mishkin suggests that the central bank should intervene only when certain informational problems make it difficult for financial markets to efficiently channel funds to productive investment opportunities. A conceptual framework is needed in order to determine when these informational problems arise. This Letter discusses a framework that is based upon theories of asymmetrical information, and it describes the trade-offs that policymakers face. THEORIES OF FINANCIAL CRISES The traditional theory of financial crises focuses on the effects of bank runs on the money supply. Other things equal, bank runs tend to reduce the money supply by increasing the public's desire to hold currency and banks' desire to hold reserves. Unless the central bank reacts by increasing the supply of currency and reserves, the money supply would fall and interest rates would rise, thus reducing the public's spending on goods and services. For example, Milton Friedman and Anna Schwartz (1963) argue that the Federal Reserve's inaction during the banking panics of the early 1930s helped turn an ordinary recession into the Great Depression. They argue that the Federal Reserve should intervene in a banking panic in order to prevent a contraction in the money supply. In addition to this effect, modern theories of financial crises focus on the consequences of asymmetrical information between borrowers and lenders. Borrowers generally know more about their investment projects than lenders, and this can lead to problems READING 11 Reprinted from Federal Reserve Bank of San Francisco Weekly Letter , No. 95-21, May 26, 1995. The opinions expressed in this article do not necessarily reflect the views of the management of the Federal Reserve Bank of San Francisco, or of the Board of Governors of the Federal Reserve System.
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PART III Financial Institutions 2 related to adverse selection and moral hazard. Adverse selection occurs when events cause low-risk borrowers to drop out of credit markets. Borrowers invest in projects that involve various payoffs and degrees of risk.
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