Reconciling Bagehot with the Fed's Response to September 11

By Antoine Martin
December 2002; Last Revised September 2004 
RWP 02-10
Research Division 
Federal Reserve Bank of Kansas City 

Abstract

      Bagehot (1873) states that in order to prevent bank panics a central bank should provide liquidity to the market at a "very high rate of interest." This seems to be in sharp contrast with the policy adopted by the Federal Reserve after September 11 when, for a few days, the federal funds rate was very close to zero. This paper shows that Bagehot’s recommendation can be reconciled with the Fed’s policy if one recognizes that Bagehot has in mind a commodity money regime so that the amount of reserves available is limited. A high price for this liquidity allows banks that need it most to self-select. In contrast, the Fed has a virtually unlimited ability to temporarily expand the money supply.

Keywords: Liquidity Provision, Lender of Last Resort, Bagehot, September 11

JEL Codes: E4, E5, G2

Antoine Martin is an economist at the Federal Reserve Bank of Kansas City. The author wishes to thank Russell Cooper, Jacob Gyntelberg, Tom Humphrey, Nobu Kiyotaki, David Laidler, Stacey Schreft, Gordon Sellon, Warren Weber, as well as seminar participants at the European Central Bank, the Bank for International Settlements, the Bank of England, the Bundesbank, the Federal Reserve Banks of Atlanta and Richmond, the London School of Economics, Iowa State University, Ohio State University, the University of Lausanne, the Missouri Economic Conference 2003, and the Midwest Macro Conference 2003 for useful comments. The author also thanks Matthew Cardillo for excellent research assistance. All remaining errors are the authors. The views expressed herein are those of the author and do not necessarily reflect the views of the Federal Reserve Bank of Kansas City or the Federal Reserve System.

Martin e-mail:  antoine.martin@kc.frb.org

Back to top       RWP home