THE MACROECONOMIC EFFECTS OF INTEREST ON RESERVES

This paper uses a New Keynesian model with banks and deposits to study the macroeconomic effects of policies that pay interest on reserves. Although their effects on output and inflation are small, these policies require major adjustments in the way that the monetary authority manages the supply of reserves, as liquidity effects vanish in the short run. In the long run, however, the additional freedom the monetary authority acquires by paying interest on reserves is best described as affecting the real quantity of reserves: policy actions that change prices must still change the nominal quantity of reserves proportionally.