Sorry but I keep thinking of notes on this – probably because I am supposed to be writing an exam.

Tyler Cowen said

[IS-LM] leads you to think that the distinction between non-interest bearing currency and short-term interest-bearing securities is a critical wedge for the economy.  It also implies that if all currency paid interest (a minor change, most likely, macroeconomically speaking), the economy would behave in a totally screwy way.  It probably wouldn’t.

This is a perfect opportunity for me to point out that paying interest on reserves does cause the economy to act in “screwy” ways.

Or to be more specific it means that the interest rate paid on reserves and not the quantity of reserves or the dynamics of the overnight lending market are determinate in monetary policy.

This is because the overnight lending rate is bound by the interest paid on reserves. You could drive reserves up to $5 trillion dollar and it won’t make a difference. Print all the money you like. Buy all the bonds you like. Lending won’t change.

That’s very different from a world where open market operations are determinant of how banks respond.

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