Reconciling Bagehot and the Fed's Response to September 11


  • I thank the anonymous referees, Russell Cooper, Jacob Gyntelberg, Tom Humphrey, Jim Kahn, Nobu Kiyotaki, Todd Keister, David Laidler, Cyril Monnet, Joao Santos, Stacey Schreft, Gordon Sellon, Warren Weber, Steve Williamson, as well as seminar participants at various central banks, universities, and conferences for useful comments. I thank Matthew Cardillo for excellent research assistance. All remaining errors are mine. The views expressed here are those of the author and not necessarily those of the Federal Reserve Bank of New York or the Federal Reserve System.


Bagehot (1873) states that to prevent bank panics a central bank should provide liquidity at a “very high rate of interest.” In contrast, most of the theoretical literature on liquidity provision suggests that central banks should lend at an interest rate of zero. This is broadly consistent with the Federal Reserve's behavior in the days following September 11, 2001. This paper shows that both policies can be reconciled. With commodity money, as in Bagehot's time, liquidity is scarce and a high price allows banks to self-select. In contrast, the Fed has a virtually unlimited ability to temporarily expand the money supply so self-selection is unnecessary.