Pegging the interest rate on bank reserves: A resolution of New Keynesian puzzles and paradoxes

Abstract

Introducing bank reserves (or money) into the basic New Keynesian (NK) model offers a resolution of NK puzzles and paradoxes. The resulting models deliver local-equilibrium determinacy under an exogenous interest rate on reserves and an exogenous nominal stock of reserves, even for an arbitrarily small monetary friction. This leads to a resolution of the forward-guidance puzzle, the fiscal-multiplier puzzle, and the paradox of flexibility. As the monetary friction becomes vanishingly small, the models converge to the basic NK model and serve to select a particular equilibrium of that model - which also offers a resolution of the paradox of toil.