30 October 2015

The Fed Should Cut IOR

It's difficult to understand why people and financial institutions would willingly carry an asset that earns less interest than other types of asset. A typical way to get around this problem is by assuming that some or all of the goods in an economy must be paid for in cash. Because agents must pay for goods in cash, they choose to hold only as much as they need to pay for those goods. If they were to hold any extra cash, then they would be missing out on valuable interest that they would earn from other assets. The cost that agents face by holding money as opposed to other assets (e.g. government bonds) is called the opportunity cost of holding money.
But what happens when the opportunity cost of holding money is zero (i.e., the interest rate on government bonds is equal to the interest rate on money)? In this situation, it makes no difference to agents what kind of asset they hold, so the distribution of government bonds and money is indeterminate. This indeterminacy breaks the link between inflation and the money supply. Typically, the money supply is linked directly with the nominal value of spending on cash-goods in this economy, so a higher money supply would necessitate higher nominal spending and, assuming flexible prices and wages, higher prices. Now, because there is no opportunity cost of holding money, agents will freely hold any money that the central bank gives them without needing to spend it.

This is the situation that the Federal Reserve is currently in. There is no incentive for financial institutions to do anything will all the money that the Fed has injected into the system since 2009 because the interest rate that money pays (interest on reserves or IOR) is equal (after adjusting for risk/liquidity) to the interest rate that other assets pay. Financial institutions are happy to sit on interest bearing and highly liquid (easy to buy and sell) cash. This is why the vast majority of the increase in the monetary base since 2009 has taken the form of "excess reserves".

In order to reverse this, it is necessary to make reserves less attractive to financial institutions (or, in the case of cash-in advance models, make cash less attractive to agents). This means that there must be an opportunity cost of holding money; that money needs to pay less interest than other assets. Of course, this can be accomplished one of two ways: the Fed can either reduce the interest it pays on reserves increase the interest rate that other assets pay. Since economists widely agree that raising interest rates would have a negative effect on the rate of inflation, it seems clear that the way to increase inflation in the US is to cut IOR.

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