Financial Crises, Payment System Problems, and Discount Window Lending

Abstract

In a developed economy, financial crises are rapidly conveyed to the payment system, which tends to rely on private credit extensions in most countries. While many authors recommend that the central bank do no more than provide adequate aggregate liquidity during a crisis, this policy requires well-functioning private credit markets to channel liquidity to solvent, but illiquid, firms. This paper presents a model of private lending which defines a crisis as a time when lenders become uncertain about how to assess financial risks and, therefore, rationally withdraw from making new loans. In such an environment, a government lender of last resort can improve social welfare. Copyright 1996 by Ohio State University Press.