Reconciling Bagehot with the Fed's Response to Sept. 11

The nineteenth-century economist Walter Bagehot maintained that in order to prevent bank panics a central bank should provide liquidity to the market at a very high rate of interest. This recommendation seems to be in sharp contrast with the policy adopted by the Federal Reserve after September 11 when, for a few days, the federal funds rate was very close to zero. This paper shows that Bagehot's recommendation can be reconciled with the Fed's policy if one recognizes that Bagehot had in mind a commodity money regime in which the amount of reserves available is limited. A high price for this liquidity allows banks that need it most to self-select. In contrast, the Fed has the virtually unlimited ability to temporarily expand the money supply