Whatever It Takes? Market Maker of Last Resort and its Fragility
43 Pages Posted: 30 Dec 2021 Last revised: 3 Jan 2024
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Whatever It Takes? Market Maker of Last Resort and its Fragility
Whatever it Takes? Market Maker of Last Resort and its Fragility
Date Written: December 31, 2023
Abstract
We provide a theoretical framework to analyze the market maker of last resort (MMLR) role of central banks. Central bank announcement to purchase assets in case of distress promotes private agents' willingness to make markets, which immediately restores liquidity to prevent disorderly sales. This, in turn, decreases the future need for the central bank to intervene. Here, the central bank can reduce the expected usage of the facility by announcing a large capacity, that is, it can end up buying less ex-post by committing to do more ex-ante. However, this beneficial feature comes with potential downsides. First, the central bank may not achieve the intended outcome due to the possibility of multiple self-fulfilling equilibria, which may arise if it does not intervene with sufficient forcefulness or if market participants have doubts about its commitment. Second, public liquidity provision may crowd out private liquidity if the MMLR access becomes permanent and make the intervention ineffective.
Keywords: market maker of last resort, liquidity, asset purchase program, multiple equilibria, time inconsistency
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