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Speculative Runs on Interest Rate Pegs

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  • Marco Bassetto
  • Christopher Phelan

Abstract

We analyze a new class of equilibria that emerges when a central bank conducts monetary policy by setting an interest rate (as an arbitrary function of its available information) and letting the private sector set the quantity traded. These equilibria involve a run on the central bank's interest target, whereby money grows fast, private agents borrow as much as possible against the central bank, and the shadow interest rate is different from the policy target. We argue that these equilibria represent a particular danger when banks hold large excess reserves, such as is the case following periods of quantitative easing. Our analysis suggests that successfully managing the exit strategy requires additional tools beyond setting interest-rate targets and paying interest on reserves; in particular, freezing excess reserves or fiscal-policy intervention may be needed to fend off adverse expectations.

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Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 18864.

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Date of creation: Mar 2013
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Handle: RePEc:nbr:nberwo:18864

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  1. Woodford, Michael, 1994. "Monetary Policy and Price Level Determinacy in a Cash-in-Advance Economy," Economic Theory, Springer, Springer, vol. 4(3), pages 345-80.
  2. Grossman, Sanford & Weiss, Laurence, 1983. "A Transactions-Based Model of the Monetary Transmission Mechanism," American Economic Review, American Economic Association, American Economic Association, vol. 73(5), pages 871-80, December.
  3. Fernando Alvarez & Andrew Atkeson, 1996. "Money and Exchange Rates in the Grossman-Weiss-Rotemberg Model," NBER Working Papers 5678, National Bureau of Economic Research, Inc.
  4. Sargent, Thomas J & Wallace, Neil, 1975. ""Rational" Expectations, the Optimal Monetary Instrument, and the Optimal Money Supply Rule," Journal of Political Economy, University of Chicago Press, University of Chicago Press, vol. 83(2), pages 241-54, April.
  5. Benhabib, Jess & Schmitt-Grohe, Stephanie & Uribe, Martin, 2001. "The Perils of Taylor Rules," Journal of Economic Theory, Elsevier, Elsevier, vol. 96(1-2), pages 40-69, January.
  6. Bassetto, Marco, 2005. "Equilibrium and government commitment," Journal of Economic Theory, Elsevier, Elsevier, vol. 124(1), pages 79-105, September.
  7. John H. Cochrane, 2011. "Determinacy and Identification with Taylor Rules," Journal of Political Economy, University of Chicago Press, University of Chicago Press, vol. 119(3), pages 565 - 615.
  8. Fernando Alvarez & Andrew Atkeson & Chris Edmond, 2003. "On the Sluggish Response of Prices to Money in an Inventory-Theoretic Model of Money Demand," NBER Working Papers 10016, National Bureau of Economic Research, Inc.
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