I believe that fiat money played an underappreciated role in the run-up to the 2008 financial crisis. In short, short-term private-sector liabilities can function as close substitutes for fiat money, resulting in inflation that only lowers the opportunity costs associated with holding short-term debt. The result is an ever more fragile system in which private sector zero-maturity money dwarfs the monetary base, inevitably culminating in collapse. While this theory is a somewhat uncommon and undoubtedly incomplete explanation for the financial crisis, the Federal Reserve seems to agree with my thinking at least in part, as demonstrated by its decision to begin paying interest on reserves. This interest makes reserves more appealing relative to risky private-sector alternatives, reducing the danger posed by depreciating fiat money. I believe that by tinkering with the nature of the reserve asset, we can structure a framework which eliminates the uncertainties associated with discreti...
Let R be the interest rate paid on excess reserves. Let G be the real economic growth rate. Let V be inflation (or money velocity). For the purposes of this thought experiment, I am going to assume that the Fed can accumulate “profit” without remitting it back to the treasury and its bond portfolio generates a return of at least G. Assume banks are flush with reserves. The Fed announces that it is going to set R=G and will be following a policy of price level targeting. What do you think happens? I think there would be minimal effect on real economic growth, and some deflation/disinflation, particularly if the Fed is credible. I think real growth would slow only if there was a fiscal response. By slowly decreasing R and purchasing treasuries with the cash we save, we will eventually stimulate the economy and put inflationary pressure. ...