Working Paper: NBER ID: w14422
Authors: Asaf Bernstein; Eric Hughson; Marc D. Weidenmier
Abstract: We use the founding of the Federal Reserve as a historical experiment to provide some insight into whether a lender of last resort can stabilize financial markets. Following the Panic of 1907, Congress passed two measures that established a lender of last resort in the United States: (1) the Aldrich-Vreeland Act of 1908 which authorized certain banks to issue emergency currency during a financial crisis and (2) the Federal Reserve Act of 1913 which established a central bank. We employ a new identification strategy to isolate the effects of the introduction of a lender of last resort from other macroeconomic shocks. We compare the standard deviation of stock returns and short-term interest rates over time across the months of September and October, the two months of the year when financial markets were most vulnerable to a crash because of financial stringency from the harvest season, with the rest of the year during the period 1870-1925. Stock volatility in the post-1907 period (June 1908-1925) was more than 40 percent lower in the months of September and October compared to the period (1870- May 1908). We also find that the volatility of the call loan rate declined nearly 70 percent in September and October following the monetary regime change.
Keywords: Lender of Last Resort; Federal Reserve; Financial Stability
JEL Codes: E4; G1; N11; N12
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Establishment of a lender of last resort (E58) | Reduction in stock return volatility (G17) |
| Establishment of a lender of last resort (E58) | Reduction in volatility of call loan rate (E43) |
| Establishment of a lender of last resort (E58) | Stabilization of financial markets during periods of heightened vulnerability (E44) |
| Stock market volatility was greater in September and October before the establishment of a lender of last resort (E44) | Pattern reversed after monetary reforms (E42) |