Pegging the Interest Rate on Bank Reserves

Abstract

We develop a model of monetary policy with a small departure from the basic New Keynesian (NK) model. In this model, the central bank can set the interest rate on bank reserves and the nominal stock of bank reserves independently, because these reserves reduce the costs of banking (i.e., have a convenience yield). The model delivers local-equilibrium determinacy under a permanent interest-rate peg. Consequently, it does not share the puzzling and paradoxical implications of the basic NK model under a temporary 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 (i.e., arbitrarily small banking costs and convenience yield of reserves).