Discount Window Policy, Banking Crises, and Indeterminacy of Equilibrium1

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 also lead to indeterminacy of stationary equilibrium and to inefficiently low levels of investment. We show that 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 distortions arbitrarily small. We also show that when the specification of the investment technology allows money to serve as an equilibrium store of value, a costless-liquidity policy can eliminate crises without generating indeterminacy. 1 We thank Huberto Ennis for valuable comments. 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.