Monetary Policy with Interest on Reserves

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In response to the emerging financial crisis of 2008, the Federal Reserve decided to increase the liquidity of the banking system. For this purpose, the Federal Reserve introduced or expanded a number of programs that made it easier for banks to borrow from it. For example, commercial banks were able to obtain additional loans through the Term Auction Facility, which the banks would then hold in their reserve accounts with the Federal Reserve. As a result of the combined financial market interventions, the balance sheet of the Federal Reserve increased from about $800 billion in September 2008 to more than $2 trillion in December 2008. Over the same time period, the reserve accounts of commercial banks with the Federal Reserve increased from about $100 billion to $800 billion. In late 2008 the Federal Reserve also announced a program to purchase mortgage-backed securities (MBS) and debt issued by government-sponsored agencies. Since then, outright purchases of agency MBS and agency debt have essentially replaced short-term borrowing by commercial banks on the asset side of the Federal Reserve's balance sheet, and the volume of outstanding reserves increased again to about $1.1 trillion by the end of 2009. Given the magnitude of outstanding reserves, there is some concern these reserves might limit policy options once the Federal Reserve decides to pursue a more restrictive monetary policy. Yet, another change in the available policy instruments might lessen this concern: Starting in October 2008, the Federal Reserve began to pay interest on the reserve accounts that banks hold with the Federal Reserve System.

How should one think about monetary policy when reserve accounts earn interest? To study this issue, I introduce a stylized banking sector into a simple baseline model of money that is at the core of much research in monetary economics. In this framework I address an admittedly rather narrowtheoretical question, but this question is fundamental to any theory of monetary policy. Namely, does the payment of interest on reserves affect issues of price level determinacy? An indeterminate price level might be undesirable since it can give rise to price level fluctuations driven by self-fulfilling expectations. In this context it is shown that the amount of outstanding reserves has only limited implications for the conduct of monetary policy.

Price level determinacy is studied in a theoretical framework that specifies not only monetary policy, but also fiscal policy, e.g., Leeper (1991) or Sims (1994). Monetary policy is described as setting a short-term nominal interest rate in response to inflation, and fiscal policy is described as setting the primary surplus in response to outstanding government debt. For the baseline monetary model without a banking sector, one obtains price level determinacy if monetary policy is active, that is, it responds strongly to the inflation rate, and fiscal policy is passive, that is, it responds strongly to government debt.1 Price level determinacy is also obtained when monetary policy is passive and fiscal policy is active. For the modified model with a banking sector, I find that this characterization of price level determinacy is not materially affected, whether or not interest is paid on reserves. I obtain a determinate price level when monetary policy is sufficiently active and fiscal policy is sufficiently passive, or vice versa. Furthermore, the magnitude of outstanding reserves may not matter at all, and if it does matter the impact of reserves is small.

Earlier theoretical work on paying interest on reserves was concerned that this policy would lead to price level indeterminacy. Sargent andWallace (1985) argue that, depending on how interest on reserves is financed, an equilibrium might not exist or the price level might be indeterminate.2 In terms of the above characterization of monetary and fiscal policy, these results obtain because the assumed financing schemes for interest on reserves make monetary and fiscal policy both passive or both active. …