Monetary policy with interest on reserves

March 2016
John Cochrane

I analyze monetary policy with interest on reserves and a large balance sheet. I show that conventional theories do not determine inflation in this regime, so I base the analysis on the fiscal theory of the price level. I find that monetary policy can peg the nominal rate, and determine expected inflation. With sticky prices, monetary policy can also affect real interest rates and output, though higher interest rates raise output and then inflation. The conventional sign requires a coordinated fiscal–monetary policy contraction. I show how conventional new-Keynesian models also imply strong monetary–fiscal policy coordination to obtain the usual signs. I address theoretical controversies. A concluding section places our current regime in a broader historical context, and opines on how optimal fiscal and monetary policy will evolve in the new regime.  

Publication Type: 
Journal of Economic Dynamics and Control
Volume 49
Issue Number: 
December 2014
Pages 74–108