Function of Central Banks as Lender of Last Resort (LOLR) - Essay Example

The crisis saw the fall of stock markets across the world and the collapse of massive financial institutions from some of the richest nations (Dorn 2010). In a bid to salvage the situation, governments, through their central banks as LOLR, came up with rescue packages with an aim of bailing out the countries’ financial systems (Brunnermeier 2009). The crisis resulted from the US sub-prime mortgage market collapse as well as the negation of the real estate boom according to (Brunnermeier 2009).

Many experts blame the current economic models for the crisis that affected lives across the globe. Advantages of LOLR During a financial crisis that hit the financial sectors, it is pointed out that many banks tend to become insolvent and sometimes collapse. In order for such a situation not to come into play, the central banks always come in an act as lender of last resort. In this case, it provides funding to increase the liquidity position of these banks. This has helped many banks escape receivership during a financial crisis (Schinasi, Teixeira and IMF.

Finance Dep. 2006 p.11). Grauwe (2011) notes that when a bank is faced with solvency problems, this in most cases can trigger deposit holders of other banks to move out their money/deposits commonly referred to as bank run. It also causes banks to start selling off their assets lowering their prices. When this continues for long, the bank may end up owing more than it can own. To solve the problem, the central bank had to play the role of lender of last resort (LOLR). Being lender of last resort was important in restoring the cascading loss of confidence among the depositors.

This is so because when investors know that they are in a position to get their money in the event of a crisis, they do not panic (Posen 2005 p.120). Central banks function as a lender of last resort is important as it acts as buyer of last resort for a country’s bonds. The loss in confidence, in this case, may lead to a liquidity problem in the other markets since there is no buyer of last resort. When this is allowed to continue for long, fears may continue until the liquidity crisis degenerates creating solvency problems.

With regard to bonds, fear creates loss of confidence which increases governments interest rates which they are required to pay in order to rollover bonds (Grauwe 2011). The high interest rates may make the country insolvent and the central bank comes in as lender of last resort (Grauwe 2011). When a financial crisis hits the financial sectors of the economy, many agents tend to hold cash for safety reasons. When the central bank comes in and acts as a lender of last resort and provides funding, it stops the deflationary process leading to stabilization of economy (Capie and Wood 2007 p.424-429). Disadvantages and Controversial Function of LOLR One of the main arguments against central bank’s function of being the lender of last resort is that it may lead to inflation (Grauwe 2011).

When the central bank buys out government bonds, it is argued that this increases the money market thereby triggering inflation. The main distinction is seen between the money stock and money base. In situations where the central bank purchases government bonds and other assets, this increases the money base. However, the money stock remains stable. For this reason, it is seen that during periods of financial meltdown, the monetary supply and monetary base become