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Working Paper, No. 2022-14, May 2022 Crossref
Money under the Mattress: Inflation and Lending of Last Resort

Central banks create money to lend during credit crunches, which might lead to inflation. We examine whether the two key functions of central banks—price stability and last-resort lending—conflict. We develop a nominal model of bank runs à la Diamond and Dybvig (1983) in which individuals can store the money they withdraw “under the mattress” or use it to buy assets. This feature allows for lending of last resort without creating inflation. Our analysis also provides a new rationale for the “Bagehot rule”: High interest rates prevent inflation, rather than mitigate the risk of lending during credit crunches.


Working papers are not edited, and all opinions and errors are the responsibility of the author(s). The views expressed do not necessarily reflect the views of the Federal Reserve Bank of Chicago or the Federal Reserve System.

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