Working Paper: NBER ID: w18864
Authors: Marco Bassetto; Christopher Phelan
Abstract: We analyze a new class of equilibria that emerges when a central bank conducts monetary policy by setting an interest rate (as an arbitrary function of its available information) and letting the private sector set the quantity traded. These equilibria involve a run on the central bank's interest target, whereby money grows fast, private agents borrow as much as possible against the central bank, and the shadow interest rate is different from the policy target. We argue that these equilibria represent a particular danger when banks hold large excess reserves, such as is the case following periods of quantitative easing. Our analysis suggests that successfully managing the exit strategy requires additional tools beyond setting interest-rate targets and paying interest on reserves; in particular, freezing excess reserves or fiscal-policy intervention may be needed to fend off adverse expectations.
Keywords: monetary policy; interest rate pegs; speculative runs; quantitative easing
JEL Codes: E42; E43; E52; E61
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Central bank interest rate setting (E52) | multiple equilibria (D50) |
| multiple equilibria (D50) | run on interest target (E43) |
| run on interest target (E43) | high inflation (E31) |
| run on interest target (E43) | monetary distortions (E39) |
| large excess reserves (F31) | severity of runs (E44) |
| size of trades with central bank (E58) | severity of runs (E44) |
| Central bank interest rate setting (E52) | divergence between shadow interest rate and policy target (E43) |
| managing interest rates insufficient for price stability (E52) | need for additional tools (C88) |