I occasionally see people claim that open market operations no longer matter in a world with IOER, where banks have large holdings of excess reserves. This is not true.

Here’s Peter Ireland from a 2014 paper:

[I]n the long run, the additional degree of freedom provided by the ability to pay interest on reserves is best described as one that gives the Federal Reserve the ability to target the real quantity of reserves separately from the federal funds rate. Even when it pays interest on reserves, the Fed must continue to use open market operations to adjust the nominal quantity of reserves proportionally, following any policy action intended to bring about a long-run change in the aggregate price level.

Even in a world with IOER, money is still neutral in the long run. The existence of IOER causes a large one-time increase in the demand for base money, say from 5% to 50% of GDP. But that’s a one-time rightward shift in the money demand curve. It’s still true that a permanent, exogenous, one-time doubling of the monetary base will cause the price level and NGDP to double in the long run.

In a 2017 paper, Ireland points out that open market operations remain effective in a world with IOER:

Thus, while the Fed’s newly-obtained ability to pay interest on reserves does allow it to tighten monetary policy by raising its federal funds rate target in the short run without any immediate open market operation, the long-run effects of this monetary policy tightening turn out to be the same with interest on reserves in figure 2 as they were in figure 1 without. From a monetarist perspective, the open market operation that leads to a contraction in the dollar volume of reserves supplied is still necessary for bringing about a permanent reduction in the price level.

Why is there so much confusion on this point? I suspect it has something to do with the various QE programs implemented during the recovery from the Great Recession. Large increases in the monetary base were accompanied by rather small increases in the price level and NGDP.

But this sort of stylized fact doesn’t mean that monetary injections are ineffective. The same people who are skeptical of the effectiveness of changing the money supply often argue that what is needed is a change in the interest rate target. However, the Fed’s policy of cutting interest rates during 2007-08 was even less effective than the QE of 2009-13, indeed far less effective.

In both cases, the policy changes were not exogenous. In 2007-08, the target interest rate was reduced because the equilibrium interest rate was declining. In 2009-13, the monetary base was expanded because the demand for base money was rising. Naturally, those policies looked ineffective; the policy changes were defensive, i.e., reactive.

In 2007-08, the Fed should have reduced the interest rate fast enough to raise NGDP growth expectations to 5%, and in 2009-13 they should have increased the monetary base enough to raise NGDP growth expectations to the 5% trend line from 2007.

In addition to Peter Ireland, Nick Rowe is someone who understands that the money supply remains important in a world with IOER. In a 2016 blog post, Nick considered a thought experiment involving an increase in the rate of interest paid on money (Rm), which might be viewed as the interest rate paid on bank reserves: 

If the central bank announces that Rm increases by 1%, and at the same time announces that money growth increases by 1%, then we get Neo-Fisherian results. The inflation rate increase by 1%, but the opportunity cost of holding money is unchanged (the increased Rm and increased inflation cancel out), so there is no initial jump up or down in the price level.

But if the central bank announces that Rm increases by 1%, and at the same time announces that money growth will not change, then we get an initial drop in the price level, because the opportunity cost of holding money has fallen so the demand for money has increased, but there is no subsequent change in the inflation rate.

If we assumed prices are sticky rather than perfectly flexible, that initial drop in the price level would take a few years of deflation to work itself out.

It’s not enough to ask what happens if the central bank changes the deposit rate of interest. We must also ask what the central bank does with the money supply. And the New Keynesians (Neo-Wicksellians) are to blame by deleting that second question, by deleting money from their model.

And by the way, my model is bog-standard ISLM, except that the central bank pays interest on money, and you can make the IS curve New Keynesian if you like, and add flexible prices or an expectations-augmented Phillips Curve.

Money still matters.