Central banks and financial stability

Question 1

What does it mean that the Central Banks acts as the lender of last resort?

Answer 1

Central Banks act as lender of last resort to secure financial stability in society.

Lender of last resort: They are the institution that in the public interest steps in when private actors no longer do so.

In a situation of crisis the central banks lend to financial institutions under stress.

That reduces the risk in the economy.

Question 2

What are the different theoretical perspectives on the effect of the lender of last resort system?

Answer 2

Dove-perspective
- We believe that the lender of last resort function is a good thing, since it will help stabilize the economy.
- We need to make sure crisis does not affect the employment and stability in society so much
- We can not afford not to help.

Hawks-perspective (counter-argument)
- It will lead to more risk taking from bankers → more crises in the future
- If people believe that they can always get help, then they will take more risks.
- Banks should not intervene: we should instead teach them a lesson, so they won’t do it again (get the rottenness out of the system)

Question 3

What is the empirical evidence on the Dove vs. Hawks debate? It the lender of last resort function a good or bad thing?

Answer 3

Generally: Doves intervene more

What is the crisis outcome?
- Economy stabilizes quicker if you help/intervene –> when you don’t help it takes longer to come back, because you choose to teach people a lesson first

• However: when doves are in charge (you intervene more) and that makes the next crisis more likely

Question 4

When do central banks usually use their function as lender of last resorts?

Answer 4

Empirical evidence:

1. In war times: They help governments finance the war by paying the government’s debt.
2. In financial crisis/financial instabilities: This is the main field where central banks take action today.