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

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. Because reserves reduce the costs of banking, the model delivers local-equilibrium determinacy under a permanent interest-rate peg. 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 of flexibility, even for an arbitrarily small departure from the basic NK model (i.e., arbitrarily small banking costs). It still solves or attenuates these puzzles and paradox for a vanishingly small departure, and also solves the of toil in that case. This limit result provides an equilibrium-selection device in the basic NK model, and brings this canonical sticky-price model at par with its sticky-information counterpart in terms of their ability to solve or attenuate the four puzzles and paradoxes.