August 1988

Panic, Liquidity and the Lender of Last Resort: A Strategic Analysis

R. Glen Donaldson


This paper develops a model in which panics are caused by the strategic behavior of agents who temporarily monopolize the supply of privately controlled cash reserves. The decision to exercise this "monopoly power" results in localized "corners" on the money market and hence an abrupt alteration in the rate of exchange between cash and non-monetary assets. This sudden appearance of a premium on liquidity produces the dramatic increase in interest rates, decrease in security prices and wave of "contagious" bank runs which are characteristic of panics. Since the nonzero probability of a panic's occurrence reduces the expected rate of return on bank deposits, individuals respond to the threat of this outcome by hoarding otherwise productive resources. As this has the effect of reducing investment­-and therefore output, consumption and government tax revenue--deposit insurance and an institutionalized of lender of last resort (which prevents panics by ensuring that the supply of legal tender is sufficiently elastic to guarantee competitive behavior among private holders of cash reserves) emerge endogenously as the result of utility maximizing behavior.

PDF: Full Paper

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Last Update: March 30, 2021