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Pegging the Interest Rate on Bank Reserves: A Resolution of New Keynesian Puzzles and Paradoxes

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Abstract

We develop a model of monetary policy with a simple departure from the basic New Keynesian (NK) model. In this model, the central bank sets independently the interest rate on bank reserves and the nominal stock of bank reserves. As long as demand for real reserves is not fully satiated, the model delivers local-equilibrium determinacy under permanently exogenous monetary-policy instruments. As a result, it does not share the puzzling and paradoxical implications of the basic NK model under a temporary interest rate peg (e.g., in the context of a liquidity trap). More specifically, it offers a resolution of the “forward-guidance puzzle,” a related puzzle about fiscal multipliers, and the “paradox of flexibility,” even for an arbitrarily small departure from the basic NK model. It still solves or attenuates these puzzles and that paradox for a vanishingly small departure, and also solves the “paradox of toil” in that case. We argue that our non-satiation assumption is reasonable for analyzing the role of monetary policy during the Great Recession.

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  • Behzad Diba & Olivier Loisel, 2019. "Pegging the Interest Rate on Bank Reserves: A Resolution of New Keynesian Puzzles and Paradoxes," Working Papers gueconwpa~19-19-05, Georgetown University, Department of Economics.
  • Handle: RePEc:geo:guwopa:gueconwpa~19-19-05
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    Cited by:

    1. Pascal Michaillat & Emmanuel Saez, 2021. "Resolving New Keynesian Anomalies with Wealth in the Utility Function," The Review of Economics and Statistics, MIT Press, vol. 103(2), pages 197-215, May.
    2. Matthew Canzoneri & Robert Cumby & Behzad Diba & Yunsang Kim, 2021. "Did the Unconventional Monetary Policy of the U.S. Hurt Emerging Markets?," Open Economies Review, Springer, vol. 32(2), pages 231-257, April.
    3. Christian Bredemeier & Falko Juessen & Andreas Schabert, 2021. "Why Are Fiscal Multipliers Moderate Even Under Monetary Accommodation?," ECONtribute Discussion Papers Series 074, University of Bonn and University of Cologne, Germany.

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    Keywords

    New Keynesian puzzles; forward guidance; interest on reserves; price determinacy;
    All these keywords.

    JEL classification:

    • E52 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Monetary Policy
    • E58 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Central Banks and Their Policies

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