Abstract: Governments use monetary policies to counteract the effects of
financial crises. In this paper we examine the subsidy that such
"safety net" policies provide to the banking industry. Using a
model of uncertainty-driven financial crises, we show that any
monetary policy designed to maintain risky investment in the face of
investor uncertainty (and thus promote economic growth and stability)
will subsidize the banking industry. In addition, we show that the
mere presence of a monetary authority willing to support a failing
banking system in bad times subsidizes the banking industry, even if
those bad times do not occur. A conditional bailout policy that does
not extend equally to all financial institutions creates a greater
subsidy for those institutions perceived as being "close" to the
central bank, possibly giving these institutions a competitive
advantage. Economic profits, in this model, are required to cover
fixed costs of entry into the banking system.
Keywords: Knightian uncertainty, safety-net subsidy, monetary and fiscal policy
Full paper (124 KB PDF)
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Last update: September 8, 1999
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