Interest on Reserves and Inflation
The payment of interest on reserves was common practice in inflationary economies such as those in Latin America and Israel. This policy may appear as paradoxical since it implies returning part of the seigniorage that was generated by the inflation process, which presumably was initiated by the government in order to obtain inflationary finance for the deficit. In this paper we argue that the motivation for paying interest on reserves in the high inflation economies can be captured by the model of the discretionary regime, where the policymakers' policies have to react to adverse expectations of the public (see Barro-Gordon 1983). In this environment the policymaker is concerned with the erosion of real liquidity by inflation, which is in part beyond his control, therefore he is willing to subsidize liquidity by paying interest on reserves. However, using the same analytical framework, we show that paying interest on reserves is an unlikely outcome for industrial economies, which are presumably closer to the rules (commitment) regime.