Excess Bank Reserves and Monetary Policy with a Lower-Bound Lending Rate September 2011

The paper posits the existence of a minimum mark-up loan interest rate threshold, which is identified using a long-term bank demand curve for excess reserves. At the threshold rate, the risk adjusted marginal revenue is equal to the marginal cost of extending loans. An excess reserves-loan (RL) equationis proposed to link excess reserves and aggregate output. The RL equation is combined with an IS equation, emphasizing the loan rate rather than the government bond rate. Together with a Phillips curve, the model is solved recursively to obtain equilibrium output and price level. The theoretical framework allows us to determine whether the unprecedented expansion of bank reserves by the Federal Reserve will engender inflation, deflation, hyperinflation or a deflationary spiral. The final outcome depends on a linear combination of five parameters and two probability regimes. The empirical results tend to support a deflation instead of an inflation regime.