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

(Revised August 2023)

This paper examines whether the two key functions of central banks—ensuring price stability and lending during crises —must be in 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. In this setting, lending of last resort does not need be inflationary. Whether it is inflationary depends on the interest rates the central bank charges. Our results suggest central banks should not charge low rates to ensure price stability, and should charge a high rate to robustly attain the ex-ante efficient outcome. These results are in line with the Bagehot rule of charging high interest rates on loans during a crisis.

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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