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The impact of paying interest on reserves in the presence of government deficit financing

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  • Mark G. Guzman

Abstract

This paper re-examines the impact that paying interest on reserves has on price level indeterminacy, price level volatility, and overall economic well-being. Unlike previous papers which examined these issues, the model developed in this paper allows the return on reserves to equal the return on government securities, which is less than the prevailing return on storage. Equally important, this model also considers how deficit financing changes the impact that paying interest on reserves has on the economy. I show that the number of steady state equilibria are equal to, or greater than, the number that arise when no interest is paid on reserves. In other words, the level of economic indeterminacy is equal to or greater than in an economy without interest payments. When the level of indeterminacy is the same, then economic volatility is reduced with the introduction of interest payments. However, when there exists greater indeterminacy in the interest-on-reserves economy, then there also exists greater volatility. In addition, under certain conditions, paying interest on reserves can be welfare enhancing. When it is not, an appropriate expansionary open market operation can offset the welfare losses associated with interest payments. Finally, under a narrow set of conditions, unpleasant monetarist arithmetic may obtain.

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Paper provided by Federal Reserve Bank of Dallas in its series Working Papers with number 0406.

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Date of creation: 2004
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Handle: RePEc:fip:feddwp:04-06

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Keywords: Bank reserves ; Interest;

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  1. Neil Wallace, 1984. "Some of the choices for monetary policy," Quarterly Review, Federal Reserve Bank of Minneapolis, issue Win.
  2. Goodhart, Charles A E, 2000. "Can Central Banking Survive the IT Revolution?," International Finance, Wiley Blackwell, vol. 3(2), pages 189-209, July.
  3. Sargent, Thomas & Wallace, Neil, 1985. "Interest on reserves," Journal of Monetary Economics, Elsevier, vol. 15(3), pages 279-290, May.
  4. Mark Toma, 1999. "A Positive Model of Reserve Requirements and Interest on Reserves: A Clearinghouse Interpretation of the Federal Reserve System," Southern Economic Journal, Southern Economic Association, vol. 66(1), pages 101-116, July.
  5. Smith, B.D., 1988. "Interest On Reserves And Sunspot Equilibria: Friedman'S Proposal Reconsidered," RCER Working Papers 119, University of Rochester - Center for Economic Research (RCER).
  6. Bruce Smith & J. Bhattacharya & Mark Guzman, 1998. "Some Even More Unpleasant Monetarist Arithmetic," Canadian Journal of Economics, Canadian Economics Association, vol. 31(3), pages 596-623, August.
  7. Marvin Goodfriend, 2002. "Interest on reserves and monetary policy," Economic Policy Review, Federal Reserve Bank of New York, issue May, pages 77-84.
  8. Robert E. Hall, 1999. "Controlling the Price Level," NBER Working Papers 6914, National Bureau of Economic Research, Inc.
  9. Marco Espinosa & Steven Russell, 1998. "Can a Policy of Higher Inflation Reduce Real Interests in the Long Run?," Canadian Journal of Economics, Canadian Economics Association, vol. 31(1), pages 92-103, February.
  10. Scott Freeman & Joseph H. Haslag, 1993. "On the optimality of interest-bearing reserves in economies of overlapping generations," Research Paper 9328, Federal Reserve Bank of Dallas.
  11. Charles Goodhart, 2000. "Can Central Banking Survive the IT Revolution?," FMG Special Papers sp125, Financial Markets Group.
  12. Jeffrey M. Lacker, 1997. "Clearing, settlement, and monetary policy," Working Paper 97-01, Federal Reserve Bank of Richmond.
  13. Bruce D. Smith, 1984. "Money and inflation in colonial Massachusetts," Quarterly Review, Federal Reserve Bank of Minneapolis, issue Win.
  14. Dwyer, Gerald Jr. & Saving, Thomas R., 1986. "Government revenue from money creation with government and private money," Journal of Monetary Economics, Elsevier, vol. 17(2), pages 239-249, March.
  15. Gale, David, 1973. "Pure exchange equilibrium of dynamic economic models," Journal of Economic Theory, Elsevier, vol. 6(1), pages 12-36, February.
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