My new Mercatus paper on IOR

I have a new Mercatus policy brief discussing interest on bank reserves. Here’s an excerpt:

After the Fed adopted a policy of IOR in late 2008, I argued that the interest rate should be set at a negative level. At the time, many scoffed at this suggestion, doubting whether the effect would be expansionary. After all, negative IOR is a tax on reserves, and we normally think of taxes having a negative impact on the economy.

But money is very different from other goods. Less demand for goods is contractionary for the economy and often leads to higher unemployment. Money is just the opposite. Less demand for money is expansionary for the economy, boosting employment. That’s because money is the other side of any transaction. People can reduce their holding of money only by purchasing goods, services, or financial assets. Thus, a tax on bank reserves (negative IOR) will tend to boost spending on other goods, services, and assets. Indeed, asset markets reacted to announcements of negative IOR in Europe and Japan as if negative IOR were an expansionary monetary policy shift.

On the other hand, people should not expect too much from negative IOR. Central banks have been reluctant to push IOR too far negative, and thus far the program has only had a modest expansionary impact, where it has been tried. In that respect it is sort of like quantitative easing (QE)—a useful tool, but often employed as a defense mechanism where the overall policy regime has failed and pushed the economy deep into recession. A better policy would be to adopt a monetary regime that did not require emergency measures such as QE and negative IOR. One such alternative policy is nominal GDP (NGDP) level targeting, at a trend rate of NGDP growth high enough to keep nominal interest rates above zero.



19 Responses to “My new Mercatus paper on IOR”

  1. Gravatar of Doug M Doug M
    13. September 2019 at 22:32

    I completely agree with you that negative IOER in 2008/09 would have been expansionary, but my framing might be a little bit different.

    I would say that paying any IOER was contractionary, as that was the new policy introduced that was introduced. Had the Fed not paid positive IOER, the interest rates on T-Bills would have been negative. The Fed being a pretty conservative bunch, thought the idea of negative rates as anathema.

    The conspiratorial part of my brain tells me that the real reason the Fed began paying IOER was as hidden subsidy to increase cashflow and income to struggling banks.

  2. Gravatar of ssumner ssumner
    14. September 2019 at 00:59

    I think it’s more likely that they wanted to rescue banks from default without easing monetary policy. Bernanke was angry at the banks—I doubt he wanted to subsidize them.

  3. Gravatar of Matthew Waters Matthew Waters
    14. September 2019 at 13:41

    The “real reason” for IOR was the wrong focus on hutting Fed Funds rate in late-2008. The Fed Funds market got really out of whack after Lehman. One day had minimum FF borrowing of 0% and maximimum FF borrowing rate of 10%.

    Before IOR, half of the new reserves were sterilized through reverse repos to other countries. The Fed also started using Treasuries instead of reserves to fund the discount window programs. They feared the Fed Funds rate plummeting to zero with new reserves.

    But the FF rate *should* have gone to zero immediately. IOR solved a problem that should have never been solved, i.e. targeting FF rate at 200 bps.

  4. Gravatar of Benjamin Cole Benjamin Cole
    14. September 2019 at 16:11

    I agree with everything in this post and even with Scott Sumner’s premise that the best defense is a good offense, in terms of monetary policy.

    Let us hope that macroeconomic policy makers and market forces allow us to constantly maintain satisfactory NGDP LT.

    Perhaps we need to prep the public that even in a growth economy, QE may be necessary as a prophylacric against recession. That central bank balance sheets, in general, become larger over time rather than smaller.

    Even with QE and negative interest rates I suspect the central banks are using rather weak tools. When we do have a recession I say send in the choppers.

  5. Gravatar of P Burgos P Burgos
    14. September 2019 at 17:27

    If IOR is negative, why hold any reserves at the Fed? Is the carrying cost lower by placing reserves at the Fed? Or is there some statutory or contractual obligations that require banks to have reserves at the Fed? But if so, then negative IOR would be a tax.

  6. Gravatar of ssumner ssumner
    14. September 2019 at 17:43

    Matthew, I agree.

    Burgos, Good question. Does anyone know the answer? All I can think is that perhaps the cost of storing currency is higher.

  7. Gravatar of dtoh dtoh
    14. September 2019 at 20:43

    For monetary policy to be effective (in expanding nominal demand,) the only thing that matters is getting the non-banking sector to exchange more financial assets for goods and services. To do this, you only have to 1) get the banking sector to buy more financial assets from the non-banking sector, and 2) make sure the non-banking sector does not increase its cash holdings.

    For 1) to work, the Fed simply needs to do OMP and to prevent the banks from building up reserves. You don’t even need negative or lower IOR rates, the Fed can just refuse deposits. And if the banks try to build up vault cash, the Fed can charge them for net increases in cash withdrawals.

    Doug – you are right about the Fed subsidizing (bailing out) the banks. It was the only politically acceptable way to recapitalize them.

  8. Gravatar of Benjamin Cole Benjamin Cole
    14. September 2019 at 22:49

    As I read what is online, Federal Reserve regulations appear to state that cash in vaults counts towards meeting a reserve requirement. The purpose of a reserve requirement is to allow banks to meet depositor demands for cash.

    I guess banks would start holding paper cash if interest on excess reserves, or even interest on required reserves, went negative.

    In this case, negative interest rates would result in US commercial banks with lots of cash stuffed in vaults. I wonder if this would have any stimulative effect. If banks start charging depositors to make deposits, I think depositors would start would migrate to holding cash, and perhaps migrate to nonbank services like Paypal to make payments.

    This is not unusual; there is already $5,000 in cash in circulation (that is cash outside banks) for every US resident, although some of that may be overseas. In Japan there is more than $8,000 in yen-equivalent for every resident, but no one seems to think global drug lords operate in yen.

    So we know even modern-day populations have a propensity to hold cash, perhaps to facilitate non-taxable enterprise.

    If the Fed goes to negative interest rates, maybe invest in Brinks (a public company) or a safe. Start up a home safe-installation company.

    The other Fed tool—quantitative easing—involved injecting injecting trillions of digitized cash into global capital markets, in the hopes of reviving the US economy.

    Well, time will tell.

  9. Gravatar of dtoh dtoh
    15. September 2019 at 03:51

    @benjamin cole

    As I said in my comment above, the Fed could just start charging for cash withdrawals above a certain amount…. just like your ATM machine. That would stop the banks (as well as firms and individuals) from holding a lot of excess cash.

  10. Gravatar of Benjamin Cole Benjamin Cole
    15. September 2019 at 08:35

    Dtoh: okay, your system might work.

    But why not cut out the middleman? Why must we execute monetary policy by working through the claptrap of a commercial banking system?

    Why not cut taxes, say Social Security taxes, and make up the difference by printing money and placing it into the Social Security system?

    I also have gathering doubts about a lone cntral bank trying to manipulate global capital markets. So the Federal Reserve injects a trillion digitized dollars into global capital markets (there is about $350 trillion of bonds capital equities capital and property in global capital markets).

    Whatever the Federal Reserve does in QE, its impact will be global, and may or may not be offset or amplified by the actions of other central banks.

    Capital markets are globalized and money is a fungible commodity.

    Proceed accordingly.

  11. Gravatar of dtoh dtoh
    16. September 2019 at 04:28


    I think we have had this discussion before…. but the market for goods and services is sticky, the market for financial assets much less so. Buying financial assets gets you a much bigger bang for your buck and it’s much less distortionary.

    As to the claptrap of the commercial banking system, transaction costs are pretty minimal and the private banks do a lot better job of risk assessment than the Fed could do.

  12. Gravatar of Christian List Christian List
    16. September 2019 at 09:39

    dtoh wrote:

    “the Fed could just start charging for cash withdrawals above a certain amount…”

    Then people would hoard cash and and employers would pay cash. No more bank accounts, no more ATMs.

  13. Gravatar of dtoh dtoh
    16. September 2019 at 10:20


    “Then people would hoard cash and and employers would pay cash. No more bank accounts, no more ATMs.”

    No. It would have exactly the opposite effect. Charging for net cash withdrawals would be exactly equivalent to a implementing a negative interest rate on cash.

  14. Gravatar of Christian List Christian List
    16. September 2019 at 12:23


    you are the expert regarding banking, so I guess I trust you on this one.

    Even though I would just hoard cash if it’s beneficial. You are just charging the withdrawal, so one needs to find a way around this. But I assume you thought of this one somehow. I assume you think the excess cash can’t leave the bank???

    I’m also a bit skeptical about more and more “asset” inflation. The perceived inflation in this area has been very high in recent years.

    And this (?) unfortunately led to political distortions, both in America and in Germany. At least in parts. One sees more and more socialist policies, or nationalist policies, or even both at the same time.

    Quite some people seem to be upset about rising rents for example. I don’t see their point, but I guess these people exist in relevant numbers. I don’t really meet these people in reality, at least not in huge numbers (I live more on the countryside), but the media says so.

  15. Gravatar of ssumner ssumner
    16. September 2019 at 15:31

    dtoh, Check out my latest post.

  16. Gravatar of Hugh D’Andrade Hugh D'Andrade
    16. September 2019 at 16:01

    Should the Fed be concerned about whether there is enough high powered money in the system?

  17. Gravatar of dtoh dtoh
    16. September 2019 at 16:52


    I saw the post, don’t know much about the ECB so I didn’t comment.

    One thing that did strike me though is that in the case of the Fed, I don’t think there is even a theoretical need for negative IOR. As far as I can tell there is no legal requirement for the Fed to accept excess reserves as deposits. So no need for a negative rate, they could just control the amount of ER by limiting the amount they are will accept as deposits from member banks.

  18. Gravatar of dtoh dtoh
    16. September 2019 at 17:05

    And just to amplify on my suggestion for controlling the amount of cash.

    The Fed could target annual net increases in cash at some rate (e.g. equal to targeted increase in NGDP plus some adjustment for expected/desired change in velocity and/or seasonal cash demands.) Then the Fed allocates the increase to member banks based on their assets (or required reserves as a proxy for assets.) Banks can make annual NET withdrawals of cash up to their allocation. Beyond that they pay a fee (e.g. 5% of the excess cash withdrawn.)

    Banks would obviously intermediate amongst themselves so no fees would be paid until the banking system as whole exceeds the aggregate target rate of cash expansion. Beyond that excess aggregate withdrawals get hit with the fee.

    This effectively has the same effect as a negative interest rate on cash, but has the advantages of…

    1. Possibly no need for new laws or regulations.
    2. No need or cost for setting up infrastructure for electronic money.
    3. No loss of anonymity for cash transactions (although some might view this as a negative.)

  19. Gravatar of ssumner ssumner
    18. September 2019 at 10:01

    Hugh, The concern is NGDP growth, which is affected by both the supply of base money (QE) and the demand (IOR). You can’t consider either in isolation.

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