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

  • Mark G. Guzman

    ()

    (Department of Eocnomics, University of Reading)

This paper re-examines the impact that paying interest on reserves has on price level indeterminacy, volatility, and economic well-being. Unlike the previous literature, this model includes an after-tax deficit that must be financed by assets (bonds and reserves) whose returns are linked. I show the number of steady state equilibria is equal to, or greater than, the number arising in the nointerest economy. Consequently, the level of indeterminacy is equal to, or greater than, in the no-interest economy. When the level of indeterminacy is the same, then economic volatility is reduced by paying interest. However, greater indeterminacy in the interest economy, results in greater volatility. Paying interest on reserves can enhance welfare and, under certain conditions, unpleasant monetarist arithmetic may also obtain.

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Paper provided by Henley Business School, Reading University in its series Economics & Management Discussion Papers with number em-dp2006-39.

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Length: 37 pages
Date of creation: 2006
Date of revision:
Handle: RePEc:rdg:emxxdp:em-dp2006-39
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Web page: http://www.henley.reading.ac.uk/

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  1. Bhattacharya, Joydeep & Guzman, Mark G. & Smith, Bruce D., 1998. "Some Even More Unpleasant Monetarist Arithmetic," Staff General Research Papers 5084, Iowa State University, Department of Economics.
  2. Smith, Bruce D, 1991. "Interest on Reserves and Sunspot Equilibria: Friedman's Proposal Reconsidered," Review of Economic Studies, Wiley Blackwell, vol. 58(1), pages 93-105, January.
  3. Marvin Goodfriend, 2002. "Interest on reserves and monetary policy," Economic Policy Review, Federal Reserve Bank of New York, issue May, pages 77-84.
  4. Lacker, Jeffrey M., 1997. "Clearing, settlement and monetary policy," Journal of Monetary Economics, Elsevier, vol. 40(2), pages 347-381, October.
  5. Robert E. Hall, 1999. "Controlling the Price Level," NBER Working Papers 6914, National Bureau of Economic Research, Inc.
  6. 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.
  7. Freeman, Scott & Haslag, Joseph H, 1996. "On the Optimality of Interest-Bearing Reserves in Economies of Overlapping Generations," Economic Theory, Springer, vol. 7(3), pages 557-65, April.
  8. 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.
  9. Gale, David, 1973. "Pure exchange equilibrium of dynamic economic models," Journal of Economic Theory, Elsevier, vol. 6(1), pages 12-36, February.
  10. 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.
  11. Bruce D. Smith, 1984. "Money and inflation in colonial Massachusetts," Quarterly Review, Federal Reserve Bank of Minneapolis, issue Win.
  12. Charles Goodhart, 2000. "Can Central Banking Survive the IT Revolution?," FMG Special Papers sp125, Financial Markets Group.
  13. Sargent, Thomas & Wallace, Neil, 1985. "Interest on reserves," Journal of Monetary Economics, Elsevier, vol. 15(3), pages 279-290, May.
  14. Goodhart, Charles A E, 2000. "Can Central Banking Survive the IT Revolution?," International Finance, Wiley Blackwell, vol. 3(2), pages 189-209, July.
  15. Neil Wallace, 1984. "Some of the choices for monetary policy," Quarterly Review, Federal Reserve Bank of Minneapolis, issue Win.
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