Working Paper Series no. 178: Financial Market Liquidity and the Lender of Last Resort

Abstract

It has been argued in the literature that emergency liquidity injections should be conducted preferably in the form of open market operations. As we show in the present paper, this is not necessarily the case when liquidity may be alternatively used for speculative purposes during the crisis. In such a situation, non-discriminating operations may attract unfunded market participants that divert funding resources away from its best uses in the financial sector. As a consequence, targeted liquidity assistance may become strictly superior. The analysis might have a bearing on recent developments in the context of the subprime crisis.

Christian Ewerhart and Natacha Valla
September 2007

Classification JEL : G14, G18.

Keywords : Liquidity, financial markets, lender of last resort.