The impact of paying interest on reserves in the presence of government deficit financing

This paper re-examines the impact that paying interest on reserves has on price level indeterminacy, volatility, and economic well-being. Unlike the previous literature, this model includes an after-tax deficit that must be financed by assets (bonds and reserves) whose returns are linked. I show the number of steady state equilibria is equal to, or greater than, the number arising in the nointerest economy. Consequently, the level of indeterminacy is equal to, or greater than, in the no-interest economy. When the level of indeterminacy is the same, then economic volatility is reduced by paying interest. However, greater indeterminacy in the interest economy, results in greater volatility. Paying interest on reserves can enhance welfare and, under certain conditions, unpleasant monetarist arithmetic may also obtain.