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Fiscal consequences of paying interest on reserves

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  • Marco Bassetto
  • Todd Messer

Abstract

We review the role of the central bank's (CB) balance sheet in a textbook monetary model, and explore what changes if the central bank is allowed to pay interest on its liabilities. When the central bank cannot pay interest, away from the zero lower bound its (real) balance sheet is limited by the demand for money. Furthermore, if securities are not marked to market and the central bank holds its bonds to maturity, it is impossible for the central bank to make losses, and it always obtains profits from being a monopoly provider of money. When the option of paying interest on liabilities is allowed, the limit on the CB's balance sheet is lifted. In this case, the CB is free to take on interest rate risk, e.g, by buying long-term securities and financing those purchases with short-term debt that pays the market interest rate. This is a risky enterprise that can lead to additional profits but also to losses. To the extent that losses exceed the profits of the monopoly operations, the CB faces two options: either it is recapitalized by Treasury, or it increases its monopoly profits by raising the inflation tax.

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  • Marco Bassetto & Todd Messer, 2013. "Fiscal consequences of paying interest on reserves," Working Paper Series WP-2013-04, Federal Reserve Bank of Chicago.
    • Handle: RePEc:fip:fedhwp:wp-2013-04
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    Cited by:

    1. Reis, Ricardo, 2016. "Funding quantitative easing to target inflation," LSE Research Online Documents on Economics 67883, London School of Economics and Political Science, LSE Library.
    2. repec:rsr:supplm:v:65:y:2017:i:5:p:122-138 is not listed on IDEAS
    3. Michele Cavallo & Marco Del Negro & W. Scott Frame & Jamie Grasing & Benjamin A. Malin & Carlo Rosa, 2018. "Fiscal Implications of the Federal Reserve's Balance Sheet Normalization," Finance and Economics Discussion Series 2018-002, Board of Governors of the Federal Reserve System (U.S.).
    4. Ricardo Reis, 2016. "Can the Central Bank Alleviate Fiscal Burdens?," NBER Working Papers 23014, National Bureau of Economic Research, Inc.
    5. Del Negro, Marco & Sims, Christopher A., 2015. "When does a central bank׳s balance sheet require fiscal support?," Journal of Monetary Economics, Elsevier, vol. 73(C), pages 1-19.
    6. Robert E. Hall & Ricardo Reis, 2015. "Maintaining Central-Bank Financial Stability under New-Style Central Banking," NBER Working Papers 21173, National Bureau of Economic Research, Inc.
    7. Eric Tymoigne & L. Randall Wray, 2013. "Modern Money Theory 101: A Reply to Critics," Economics Working Paper Archive wp_778, Levy Economics Institute.
    8. Keister, Todd & Martin, Antoine & McAndrews, James J., 2015. "Floor systems and the Friedman rule: the fiscal arithmetic of open market operations," Staff Reports 754, Federal Reserve Bank of New York.
    9. Margarita Irizepova, 2015. "Methods of State’s Reaction to Risks of State Finances Management," European Research Studies Journal, European Research Studies Journal, vol. 0(3), pages 129-136.
    10. Roberto Robatto & Pierpaolo Benigno, 2016. "Private Money and Equilibrium Liquidity," 2016 Meeting Papers 690, Society for Economic Dynamics.
    11. Margarita Irizepova, 2015. "Historical Evolution of Economic Category “State Financial Reserves”," European Research Studies Journal, European Research Studies Journal, vol. 0(3), pages 103-114.
    12. Benigno, Pierpaolo & Nisticò, Salvatore, 2015. "Non-Neutrality of Open-Market Operations," CEPR Discussion Papers 10594, C.E.P.R. Discussion Papers.
    13. Cavallo, Michele & Del Negro, Marco & Frame, W. Scott & Grasing, Jamie & Malin, Benjamin A. & Rosa, Carlo, 2018. "Fiscal Implications of the Federal Reserve's Balance Sheet Normalization," Working Papers 747, Federal Reserve Bank of Minneapolis.
    14. Reis, Ricardo, 2015. "Comment on: “when does a central bank’s balance sheet require fiscal support?” by Marco Del Negro and Christopher A. Sims," LSE Research Online Documents on Economics 65867, London School of Economics and Political Science, LSE Library.
    15. repec:eee:jebusi:v:91:y:2017:i:c:p:1-15 is not listed on IDEAS
    16. Cavallo, Michele & Del Negro, Marco & Frame, W. Scott & Grasing, Jamie & Malin, Benjamin A. & Rosa, Carlo, 2018. "Fiscal implications of the Federal Reserve's balance sheet normalization," Staff Reports 833, Federal Reserve Bank of New York.

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