Whatever it takes? Market maker of last resort and its fragility

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 decreasing the need for future intervention. That is, the central bank can reduce the usage of the facility ex post by announcing a large capacity ex ante. This comes with potential fragility due to the possibility of multiple equilibria. Central bank can eliminate the bad equilibrium by announcing a large enough facility. However, fragility resurfaces if market participants doubt central bank’s commitment. Furthermore, permanent access to MMLR may crowd out private liquidity making the intervention ineffective.