A negative interest rate on reserves is effectively a tax on the banking system. The rationale for adopting such policy in the context of a classic liquidity trap is its expansionary effect, via the reduction in the incentive to save. However, critics argue that the distortion in the banking system may well have adverse effects which outweigh the welfare gains from economic stimulus. This paper contributes to the debate by modelling the banking sector in accordance with the maturity-transformation framework of Diamond and Dybvig (1983). I show that, on the one hand, negative interest on reserves leads to financial disintermediation, which reduces the extent of maturity transformation below the first-best level; while, on the other hand, it is expansionary, as consumers save less overall. The paper's main finding is that, while in normal times taxing banks is inefficient, optimal monetary policy in the liquidity trap prescribes a strictly negative interest on reserves.
IMF Working Paper, February 2016 Read online
Structural reforms in the liquidity trap need not be deflationary. This paper develops a simple framework to study the role that key characteristics of Japan’s labor and product markets—labor-market duality and weak corporate governance—play
in generating unfavorable wage-price dynamics. The model allows a discussion of whether and in what form structural reforms may contribute to Japan’s short-run goal of reflating the economy. It finds that boosting inflation with structural
reforms implies an unusual trade-off with employment, that is an inverted Phillips curve. Simultaneous implementation of labor-market and product-market reforms is most effective in terms of reflating the economy.
Work in Progress
“A Theory of Liquidity and Interest on Reserves”
A well-known result of the Diamond-Dybvig model is that the existence of financial markets curtails provision of liquidity-risk insurance by the banking system. The model’s equilibrium allocation has inefficiently low investment in short-term assets. Farhi et al. (2009) propose imposing a reserve requirement on banks in order to increase investment in short-term assets. In a model where consumers are restricted to investing their wealth in bank deposits, they show that a reserve requirement can implement the efficient allocation. This paper extends the model: consumers can invest their wealth directly in financial markets as well as in bank deposits. In such set-up, I find that a reserve requirement does not lead to more aggregate investment in short-term assets. In fact, since a reserve requirement is effectively a tax on bank deposits, consumers respond to it by reducing their holdings of deposits. Instead of attempting to force banks to hold more short-term assets by regulation, the government can incentivise them to do so by paying interest on reserves. The paper’s main result is that the efficient level of liquidity-risk insurance can be implemented by a policy of paying strictly positive interest on bank reserves.
Work in Progress
“Debt, Deleveraging and the Liquidity Trap, or Nominal GDP Level Targeting”
This paper analyses the relationship between debt and liquidity traps. I study deleveraging shocks, as in Eggertsson and Krugman (2012), and find that they imply nominal GDP level targeting as the optimal monetary policy. When a deleveraging shock takes place, consumers with high propensity to consume are forced to pay back part of their debt. This is contractionary at the macroeconomic level and, if assets are nominal, the effects are amplified by Fisher’s debt-deflation effect. I show that this amplification mechanism, whereby deleveraging gives rise to deflation and hence to further deleveraging can be counteracted by a central bank targeting the nominal GDP level. Intuitively, the central bank is stabilising the debt-to-GDP ratio of the economy. This prevents the economy from falling into deleveraging-induced liquidity traps.