Limited Commitment and Central Bank Lending

Abstract

This consideration of central bank lending as a publicly provided line of credit begins by describing how private line-of-credit contracts control moral hazard and limit lending to insolvent borrowers. The fundamental problem for a central bank is to credibly commit to limit its lending. Failure to do so creates moral hazard with adverse consequences. Of five candidate approaches to the commitment problem – namely, good offices only, collateral and early intervention, constructive ambiguity, extended supervisory and regulatory reach, and building a reputation for not lending – only the last will work in practice. Lessons from the historical acquisition of credibility for low inflation suggest a particular scenario by which a central bank could gradually acquire a reputation for limiting its lending commitment.