Tuesday, March 18, 2014

Paying interest on reserves is a nonsense.

Frances Coppola (if I’ve got her right) argues herethat where commercial banks have unprecedented amounts of reserves, the central bank can still control lending by uping the interest paid on those reserves. But that throws up an absurdity, as follows.
If I decided to keep thousands under my matress in the form of physical cash, and someone suggested that government / central bank / taxpayers should pay me interest for that useless activity, that would be regarded as a joke. But physical cash is base money: just like reserves. I.e. paying interest on reserves is as absurd as paying people to keep cash under their matress.
I suggest the solution to that absurdity is that the currency issuer, ideally, should never pay anyone simply to hold currency. Instead, demand should be controlled by controlling the AMOUNT of currency issued. And indeed the latter policy has been or is advocated by others: e.g. Prof. Richard Werner, Positive Money, Warren Moslerand (as far as I can see) Milton Friedman at one point in his career. Thus if and when central banks start dishing out large amounts of taxpayers’ money to banks (and hence bank customers) for effectively keeping cash under their matresses, the latter individuals and groups will have a good chortle.
Moreover, two recent studies have shown that interest rate adjustments are pretty ineffective in regulating demand. See hereand here.

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