The Optimal Conduct of Monetary Policy with Interest on Reserves

In a world with interest on reserves, the central bank has two distinct tools that it can use to raise the short-term policy rate: it can either increase the interest it pays on reserve balances, or it can reduce the quantity of reserves in the system. We argue that by using both of these tools together, and by broadening the scope of reserve requirements, the central bank can simultaneously pursue two objectives: it can manage the inflation-output tradeoff using a Taylor-type rule, and it can regulate the externalities created by socially excessive short-term debt issuance on the part of financial intermediaries. (JEL E43, E52, E58, G21)