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Fiscal Consequences of Paying Interest on Reserves

Bassetto, M; Messer, T; (2013) Fiscal Consequences of Paying Interest on Reserves. Fiscal Studies , 34 (4) 413 - 436. 10.1111/j.1475-5890.2013.12014.x. Green open access

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Abstract

We review the role of the central bank's balance sheet in a textbook monetary model and explore what changes if the central bank is allowed to pay interest on its liabilities. When the central bank (CB) cannot pay interest, away from the zero lower bound its (real) balance sheet is limited by the demand for money. Furthermore, if securities are not marked to market and the central bank holds its bonds to maturity, it is impossible for the CB to make losses, and it always obtains profits from being a monopoly provider of money. When the option of paying interest on liabilities is allowed, the limit on the CB's balance sheet is lifted. In this case, the CB is free to take on interest-rate risk – for example, by buying long-term securities and financing those purchases with short-term debt that pays the market interest rate. This is a risky enterprise that can lead to additional profits but also to losses. To the extent that losses exceed the profits of the monopoly operations, the CB faces two options: either it is recapitalised by Treasury or it increases its monopoly profits by raising the inflation tax.

Type: Article
Title: Fiscal Consequences of Paying Interest on Reserves
Open access status: An open access version is available from UCL Discovery
DOI: 10.1111/j.1475-5890.2013.12014.x
Publisher version: http://dx.doi.org/10.1111/j.1475-5890.2013.12014.x
Additional information: © 2013 The Authors Fiscal Studies © 2013 Institute for Fiscal Studies. Full text made available to UCL Discovery by kind permission of Wiley.
Keywords: interest-rate risk, quantitative easing, monetary-fiscal interaction, excess reserves, central bank, E52, E58, E61, E63, H63
UCL classification: UCL
UCL > Provost and Vice Provost Offices > UCL SLASH
UCL > Provost and Vice Provost Offices > UCL SLASH > Faculty of S&HS
UCL > Provost and Vice Provost Offices > UCL SLASH > Faculty of S&HS > Dept of Economics
URI: https://discovery.ucl.ac.uk/id/eprint/1402875
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