Discount Window Policy, Banking Crises, and Indeterminacy of Equilibrium

We examine optimal discount window policy in an economy with a linear investment technology and aggregate liquidity shocks. Unrestricted lending at the discount window prevents large shocks from causing banking crises, but leads to indeterminacy of stationary equilibrium. We show how a policy of offering discount-window loans at an above-market interest rate generates a unique stationary monetary equilibrium. Under such a policy, banking crises occur with positive probability in equilibrium, but a proper choice of interest rate can make the welfare loss due to these crises arbitrarily small. We then modify the model by introducing diminishing returns to investment and show that, in this case, the optimal policy may eliminate banking crises entirely. 1 We are deeply indebted to Bruce Smith for his useful comments and for many years of encouragement and support. We gratefully acknowledge financial support from the Weidenbaum Center on the Economy, Government, and Public Policy at Washington University. Part of this work was completed while Keister was visiting the University of Texas at Austin, whose hospitality and support is also gratefully acknowledged.