DP11578 | Achieving Price Stability by Manipulating the Central Bank's Payment on Reserves

Publication Date

10/19/2016

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Abstract

Today, all major central banks pay or collect interest on reserves, and stand ready to use the interest rate as an instrument of monetary policy. We show that by paying an appropriate rate on reserves, the central bank can pin the price level uniquely to a target. The essential idea is to index reserves to the market interest rate, the price level, and the target price level in a way that creates a contractionary financial force if the price level is above the target and an expansionary force if below. Our payment-on-reserves policy process does not require terminal conditions like Taylor rules, exogenous fiscal surpluses like the fiscal theory of the price level, liquidity preference as in quantity theories, or local approximations as in new Keynesian models. The process accommodates liquidity services from reserves, segmented financial markets where only some institutions can hold reserves, and nominal rigidities. We believe it would be easy to implement.