The Bank of Israel - Vol. 1

By Haim Barkai; Nissan Liviatan | Go to book overview

Appendix D: Interest on Reserves
and Core Inflation

In inflationary economies, it was common practice for the central bank to pay interest on commercial banks’ reserve requirements. This was in fact one of the main forms of monetary accommodation that can be used to illustrate two features of chronic inflation, the implications of monetary accommodation and the concept of core inflation.

We explore these issues within the framework of a one-period loss function under stationary conditions. The net inflation tax (NIT) is given by [(π−R)h], where π denotes actual inflation and we assume (without loss of generality) that R is the interest rate paid directly on monetary base h, which is assumed to be identical with means of payment (money).1 We assume that h is composed solely of bank reserves. We prefer, for simplicity’s sake, the use of NIT rather than of net seigniorage, defined as (μ−R)h where μ is the rate of expansion of base money. This remark pertains only to the optimization stage, whereas in a stationary equilibrium NIT is of course identical with net seigniorage, which in turn is equal to the operational fiscal deficit.

We shall assume that in each period the policymaker has full control over actual inflation and will use it accordingly as a policy instrument at the optimization stage. Monetary expansion η is then adjusted endogenously to satisfy the money market equilibrium. The simplest way of thinking about real money balances within the framework of a one-period model is as a variable factor of production of output. The demand for real balances will then be a negative function of expected inflation.

Although the government can produce money at no cost, it may not try to reach the satiation level, at which the marginal product of real money balances is zero. The basic reason for this statement is that by restricting the use of

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