The Impact of Paying Interest on Reserves in the Presence of Government Deficit Financing

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This paper reexamines 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 financed by assets (bonds and reserves) whose returns are linked. I show that the number of steady-state equilibria and the corresponding level of indeterminacy are equal to, or greater than, those arising in the no-interest economy. When the level of indeterminacy is the same, the economic volatility is reduced by paying interest. However, greater indeterminacy in the interest economy results in greater volatility. Finally, paying interest on reserves can enhance welfare. (JEL D6, E3, E5)

I. INTRODUCTION

The issue of paying interest on reserves was introduced by Friedman almost 50 years ago in A Program for Monetary Stability. Friedman's original motivation was to make the 100% reserve requirement of the "Chicago Plan" more palatable to a banking system subject to only a fractional reserve system. The goal of the Chicago Plan and the proposal to pay interest on reserves was to establish greater price level stability and to reduce excessive price level fluctuations. (1)

In the subsequent decades, there has been considerable research regarding the implications of paying interest on reserves. (2) Three studies, in particular Sargent and Wallace (1985), Smith (1991), and Freeman and Haslag (1996), have examined in detail whether Friedman's proposal would bring about the desired reductions in price level indeterminacy and volatility, as well as the welfare implications of switching from a system of not paying interest on reserves to one which did. (3)

However, these works suffered from two specific limitations. First, they did not equate the interest paid on reserves to returns on assets of similar risk and duration. Second, they assumed that the government either ran a balanced budget or had a surplus.

By assuming that the budget was not in deficit, these works sidestepped two important issues: (a) the impact that deficit financing has on the means for financing interest payments and (b) the complications that arise from simultaneously attempting to finance a deficit and set the real return on reserves. One of the key results of this previous literature was that how interest payments were financed was crucial to the likelihood of indeterminacy and volatility arising. However, if the sum of government expenditures and interest payments (on bonds and reserves) exceeds tax revenue, then the issue of how interest payments on reserves are financed (via taxes or earnings on assets) is no longer relevant. Instead, the appropriate concern is whether the government can simultaneously finance the deficit (by issuing bonds or printing money), link the return on reserves to other assets (such as bonds), and maintain sufficient returns on bonds and reserves such that both assets are desired by consumers.

The objective of this paper is to reexamine, in the presence of an after-tax deficit, the impact of switching from a system where reserves earn no interest to one where they do. This is accomplished in the context of a two-period overlapping generations model with multiple assets and an after-tax government deficit that must be financed by a combination of debt and seigniorage income. The primary goal is to compare the level of economic indeterminacy, economic volatility, and welfare gains in an economy where interest is paid on reserves to one where reserves earn no interest.

More specifically, this paper addresses the following three questions. First, in the presence of a government deficit and a return on storage that dominates all other rates of return, does paying interest on reserves reduce potential indeterminacy of equilibria? Second, under the same conditions, does the amount of economic volatility increase or decrease? Third, are there any welfare justifications for switching to a sys tem where reserves earn interest? …