Arnold Kling  

An Assignment for Mark Thoma

Policy Focus... Morning Libertarian Rant...

He claims that there is not much that the Fed can do to contribute to the recovery. I would like for Mark or for Paul Krugman to write an essay on the topic of what would happen if tomorrow the Fed stopped paying interest on reserves. I think I can guess what Scott Sumner might write..

My own view is that we would soon find out what the limits are of demand expansion policies. I think that the economy would have a lot of Recalculating to do, but it would have more than enough demand stimulus.

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CATEGORIES: Monetary Policy

COMMENTS (9 to date)
Richard A. writes:

If tomorrow the Fed stopped paying interest on reserves, I suspect you would begin seeing the recovery of the M1 money multiplier. If this were to fail, then congress should give the Fed the power to experiment with paying negative interest rates on excess reserves.

BTW, if the money multiplier were to make a quick and full recovery, with the present size of the monetary base, the economy would be over stimulated.

Bob Murphy writes:

Arnold, this is a fantastic post! If they don't answer you, please write up your full analysis so that they may be goaded into responding.

Leigh Caldwell writes:

I suspect Scott would write: not much, unless they also set a new price level or NGDP target.

This is, maybe not that surprisingly, just what Mark Thoma says. Though he seems more inclined to fiscal rather than monetary stimulus as a way of credibly promising an increase in NGDP.

Doc Merlin writes:

@Leigh Caldwell:

Scott actually proposed them paying negative interest on reserves last year.

Leigh Caldwell writes:

Hi Doc

I remember it well, and have discussed it with him. But I don't think he believes this would make the difference on its own.

It's all part of a package - in the absence of a formal price level/NGDP target, the Fed's intentions are full of ambiguity. Paying interest on reserves sends a signal that they are more interested in controlling money supply than boosting growth; so I agree that reversing the policy would make some difference. But, especially after all the Fed's vacillation so far, I can't imagine that one step being enough to really help.

Jim Rose writes:

I recall Greg Mankiw asking in the context of real business cycle theory could the Fed cause a recession if it really tried?

A variation of this put your money where your mouth is question is the fiscal policy value of a quantitative easing when monetary policy is said to be impotent because of a liquidity trap or the zero interest rate bound.

Auerbach and Obstfeld explored this recently in the American Economic Review in “The Case for Open-Market Purchases in a Liquidity Trap”.

To the extent that long-term interest rates are positive now or short-term interest rates are expected to be positive in the future, trading money for interest-bearing public debt through open market operations reduces future debt-service requirements. A massive monetary expansion during a liquidity trap should improve welfare by reducing the taxes required in the future to service the now much smaller national debt!!!!

Auerbach and Obstfeld did not take their reasoning further and welcome liquidity traps because of the opportunity they present to reduce the public debt at minimal fiscal costs. A quantitative easing during a liquidity trap is, in effect, as good as or even better than a lump sum tax.

Central banks perhaps should contrive liquidity traps because they can then buy back the public debt because of the unlimited demand for money. People at home and abroad will, without limit, give up bonds for non-interest bearing cash.

If monetary policy is impotent near the zero bound, the Fed should buy trillions of dollars’ worth in federal bonds and payoff the public debt. This is a logical implication of liquidity traps for an optimal fiscal policy!!!!

I am sure that when pressed on this fiscal policy paradox, Keynesian macroeconomists will quickly mumble, although there are no inflationary or other risks within the Keynesian prism from this course of policy action.

kharris writes:

We cannot know the limits of demand management merely by examining the results of monetary policy at the zero bound. I assume you know that. Glib, and not all that honest.

David Pearson writes:

I agree with Leigh. In the absence of an inflation target, the response of banks to a 25bp lower IOR would be minimal.

The inflation target is a penalty on cash hoarding. The question is, how much of a penalty is needed to counteract household's desire for "deflation insurance"? Sumner thinks its minimal -- around 3.5% for one year, and 2% thereafter. I suspect Bernanke would say the penalty is higher, and that he is reluctant to raise long term inflation expectations.

In any case, reducing the IOR to zero would be important, as it would signal the Fed's willingness to use it as a policy tool to go below the zero bound.

I think Mark in his reply to this post makes a good argument, but with 41 Republicans and the disgraceful rules of the Senate and the Republicans unprecedented willingness to abuse them to the max, it's just very unlikely to happen anytime soon at a large scale, if at all.

But what if the rate on reserves was cut to negative?

You really forced banks to disgorge money.

Could this do a substantial amount?

It has the great advantage that neither Lacker, nor any of the other bank presidents can stop Bernanke from cutting the interest rate on bank reserves to negative (seems legal from my quick read of the law). It's little known that Board of Governors decides the rate on reserves, after an amendment to the Federal Reserve Act, not the FOMC. And Bernanke can probably get the two other votes he needs on the Board to get this approved if he really wants to.

From Stephen Williamson:

My previous post, point 1, reflects some ignorance on my part (the ignorance has now been corrected). The Federal Reserve Act specifies that decisions about the interest rate on reserves are made by the Board of Governors, not by the FOMC. Obviously Congress did not think through the issue properly when it amended the Act. Since the interest rate on reserves is now the key policy rate, decisions about how to set it would appropriately reside with the FOMC.


I like stimulating the economy better with high return social investments of the kind the pure free market will grossly underprovide or ineficiently provide due to long established in economics pure free market problems like externalities, giant economies of scale yet monopoly problems, etc. Monetary stimulus just increases GDP in the same consumption heave ineficient, lower growth proportions, rather than changing the proportions. But fiscal is just not passable right now.

Nonetheless, if I might assigne you some homework Arnold; please read – and really think – about this short column from Cornell economist Robert Frank on the ginormous positional/context/prestige externalities:

and please read this quote from the great growth economist Paul Romer of Stanford:

As just one example, recall that the increasing returns to scale that is implied by nonrivalry leads to the failure of Adam Smith’s famous invisible hand result. The institutions of complete property rights and perfect competition that work so well in a world consisting solely of rival goods no longer deliver the optimal allocation of resources in a world containing ideas.

– Forthcoming American Economic Journal paper, page 8, at:

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