Monetary Policy in Times of Crisis: The Increasing Need for Central Banks to Operate as Lenders of Last Resort.

In the following project I investigate whether or not ensuring financial stability through unconventional lender of last resort (LOLR) policies has become a necessary function for central banks in times of crises. We find that residuals from Goodhart’s (1999) regression model indicate that conventional monetary policy during times of crisis is not as effective in achieving its goals. Bank failures and disorderly defaults, in general, cause uncertainty that is extremely destabilizing for the financial system. Our analysis indicates that several central banks including the Fed, the National bank of Denmark, the Riksbank and the Bank of England have had important LOLR responses over the last few years. In addition to these banks the ECB during the sovereign debt crisis also eventually had to conduct unconventional monetary policy in order to ensure financial stability, despite that the ECB’s mandate does not include this role. Our analysis indicates that it is important for central banks to ensure financial stability by taking on the role of the LOLR. In addition we compare and contrast various theories on the LOLR and conclude that there are some limitations with the classical LOLR proposals. Finally, we conclude that LOLR policies and deposit insurance are necessary in today’s financial environment but must come hand in hand with proper regulations, reforms, restrictions and supervision of banks and public finances in the case of Eurozone countries. For the Eurozone periphery countries we also argue that these reforms have to promote efficient spending of public finances and eventual reduction of public debt, however extreme austerity is not the solution. We argue that the IMF’s demands for austerity measures in exchange for bailouts only prolong the crisis, promote greater uncertainty in Europe and are not consistent with an efficient LOLR that can quickly restore financial stability. Finally in Europe we find that in the absence of an institution like the US treasury that can provide social transfers, a LOLR is even more essential