Abstract: The Macroeconomic Effects of Allowing Interest Payment on Demand Deposits

Extract

This papaer assesses some of the costs and benefits of aloowing banks to pay interest on demand deposits. With the help of a simple short-run model of the financial sector, it is shown that, barring a possible but unlikely perverse reaction, the deposit rate will tend to move in the same direction as other rates. This will moderate changes in the money supply accompanying a given change in interest rates; conversely, a given change in the excess demand for money will cause larger fluctuations in the level of interest rates. This can either be good or bad; if the excess demand for money corresponds to an excess demand for real output, the wider fluctuations in the interest rate will be more effective in eliminating it.