Pegging the Interest Rate on Bank Reserves: A Resolution of New Keynesian Puzzles and Paradoxes

Behzad Diba and Olivier Loisel

Working Papers from Georgetown University, Department of Economics

Abstract: We develop a model of monetary policy with a simple departure from the basic New Keynesian (NK) model. In this model, the central bank sets independently the interest rate on bank reserves and the nominal stock of bank reserves. As long as demand for real reserves is not fully satiated, the model delivers local-equilibrium determinacy under permanently exogenous monetary-policy instruments. As a result, it does not share the puzzling and paradoxical implications of the basic NK model under a temporary interest rate peg (e.g., in the context of a liquidity trap). More specifically, it offers a resolution of the “forward-guidance puzzle,” a related puzzle about fiscal multipliers, and the “paradox of flexibility,” even for an arbitrarily small departure from the basic NK model. It still solves or attenuates these puzzles and that paradox for a vanishingly small departure, and also solves the “paradox of toil” in that case. We argue that our non-satiation assumption is reasonable for analyzing the role of monetary policy during the Great Recession.

Keywords: New Keynesian puzzles; forward guidance; interest on reserves; price determinacy (search for similar items in EconPapers)
JEL-codes: E52 E58 (search for similar items in EconPapers)
Pages: 93
Date: 2019-08-28
New Economics Papers: this item is included in nep-cba, nep-dge, nep-mac and nep-mon
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (1)

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Journal Article: Pegging the interest rate on bank reserves: A resolution of New Keynesian puzzles and paradoxes (2021)
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