Temporary Bubbles and Discount Window Policy

Abstract

This paper presents a monetary growth model where limited communication and random relocation create endogenous roles for money and banks. The economy can exhibit two different regimes. In the first, money is a dominated asset and banks economize cash reserves. In the second, money has the same return as capital and banks use the reserves as storage. I show that the economy can experience switching between the two regimes and that cyclical bubbles can occur. In addition, discount window lending is considered as a counter-bubble policy. I also show that the discount window can simultaneously lead the economy to the social optimum and stabilize bubbly fluctuations when the economy is dynamically inefficient.