Sunday, April 11, 2010

Interest Payment on Excess Reserves Smackdown

Thomas Palley provides a critique of the Fed's policy of paying interest on excess reserves:
The Federal Reserve has recently activated its newly acquired powers to pay interest on reserves of depository institutions. The Fed maintains its new policy increases economic efficiency and intends it to play a lead role in the exit from quantitative easing. This paper argues it is a bad policy that (1) has a deflationary bias; (2) is costly to taxpayers and that cost will increase as normal conditions return; and (3) establishes institutional lock-in that obstructs desirable changes to regulatory policy. The paper recommends repealing the Fed’s power to pay interest on bank reserves. Second, the Fed should repeal regulation Q that prohibits payment of interest on demand deposits. Third, the Fed should immediately implement an alternative system of asset based reserve requirements (liquidity ratios) that will improve monetary control and can help exit quantitative easing at no cost to the public purse. Now is the optimal time for this change. Lastly, the paper argues the new policy of paying interest on reserves reveals the troubling political economy governing the actions of the Federal Reserve and policy recommendations of the economics profession.
Read the rest here.


  1. David, in more advanced countries like Canada I believe they have been paying interest on reserves for sometime. In yet more advanced countries like the UK there are no reserve requirements either. So what's the big deal?
    BTW, Stephen Williamson, author of my favorite intermediate macro textbook, has some blog entries on this very topic at

  2. David,

    The elasticity of Excess Reserves to the IOR has not been, to my knowledge, explained in detail. The writer you cite implies it is quite high: that is, reducing the IOR to zero would result in a large conversion of ER's to RR's (fueling credit growth).

    My question is, what do most economists assume is the price-elasticity of ER's? Or, more important, what does the Fed believe this elasticity to be? Because by saying that they, "have the tools" to manage ER's, they imply that they "know the elasticity," -- for without knowledge of the latter, you cannot claim the former.

    In the absence of a priori knowledge one can rely on experimentation based on incremental moves in the IOR. This was the essence of Greenspan's "measured pace" rate hike campaign. The question then becomes whether the elasticity is a stable linear function that can be discovered through incremental steps; or whether it is a non-linear or shifting (influenced by other factors) function; or finally, whether telegraphed incrementalism causes important market distortions (principally a decline in expected rate volatility which drives a dramatic expansion in Value at Risk)?

    It seems the essence of nominal targeting regimes is incrementalism: that small changes in the IOR will yield small changes in growth of the aggregates (especially second derivative changes), such that "discovery" elasticities is essentially costless. IMO, this is confusing, as, in the view of some targeting proponents, small, predictable moves in the FF rate during 2007 obstensibly caused a crash in NGDP during 2008. This would imply an unstable and/or non-linear relationship between policy rates and reserve behavior, at least at that point in time.

  3. ECB, you must have exceptional students to be using Stephen Williamson's textbook. My understanding is that it is an intense microfoundations-based macro text that makes students cry. I use Abel-Bernanke-Croushore. I would love to hear why you use the Williamson't textbook and how your students handle it.

  4. David:

    That is a great question. I have not found any study that estimates the elasticity of ER (though I have not searched extensively). It seems that folks like the author simply assume a high elasticity without any evidence.