Scott partially answered my question (which I posted here for your viewing convenience), but he didn’t elaborate on why he uses the formula (i-IOR) to get his desired result that IOR is contractionary, even though higher interest rates per se are expansionary. (It should go without saying that I’m just dabbling within Scott’s framework to make sure it’s internally consistent. Obviously I don’t think it’s useful to classify “boosting NGDP” as “expansionary” etc.)
In the comments here at Free Advice, Aaron gave the natural answer:
i–IOR is th relevant number because IOR is the floor at which banks will lend. No one in their right mind will lend below IOR.
Before IOR, the floor was zero, so i–IOR = i. Now is not. So to compare historic data, your have to subtract IOR.
I agree that this is probably the reasoning Scott is using (though he never spelled it out). But if so, there are some problems. Very quickly:
==> Banks aren’t the only actors in the economy. There are businesses and households that hold cash balances, and factor interest rates into their decisions. So if interest rates across the economy go up because the Fed hikes IOR, then doesn’t that make everybody in the economy less eager to hold cash balances? Yet only the commercial banks are getting the subsidy. To switch examples: If the federal government starts stockpiling wheat and thereby raises the market price, that would still cause consumers to buy less bread. We wouldn’t say, “Nah, this is a subsidy and so the relevant metric is b-w, where b is the market price of bread and w is the subsidy price the government pays farmers for wheat.”
==> Even if we focus just on the commercial banks, it’s not obvious to me that they only care about the spread, as opposed to the absolute value of the market interest rate. The reason is that the Fed is simply a very safe borrower, from the perspective of the commercial banks. For example, forget about IOR; imagine it’s back in 2004 before that policy. Now some major housing developers approach the commercial banks looking to borrow money, and that pushes up market interest rates from 3% to 4%. Would Scott say that this isn’t expansionary, because the banks really care about (i-d), which is the market interest rate minus how much they can earn if they lend to the developers? Of course not; that doesn’t even make sense. So by the same token, when the Fed comes along and says, “Hey, if you ‘lend’ your reserves to us, we’ll pay you 25 bps instead of 0 bps,” I don’t see why that is qualitatively different from increased demand for reserves from any other borrower.
==> Even if you think the above two points are wrong, I have a third, independent problem with Scott’s analysis. Let’s say the Fed raises IOR by 25 basis points. Scott wants to say, “That’s contractionary because the relevant metric is i-IOR, and the Fed just raised IOR.” But hold on. An immediate reaction is for i to rise in response. Without Scott telling us more, I think most people would assume market interest rates in turn would all rise by 25 bps as well. So it would seem to a first approximation–using Scott’s stipulated framework–IOR should have no effect. In other words, any increase in IOR will presumably cause i to increase by the same amount, and so the metric (i-IOR) is unaffected by the policy of IOR. And yet Scott has spent the last 7 and a half years arguing quite vigorously that IOR is contractionary.
If this were just some minor point, I wouldn’t be making such a big deal out of it. But since the issue of IOR (and the possibility of negative IOR) has been floated for years by Market Monetarists as the smoking gun against the liquidity trap, I think Scott should at some point clarify how all this works, when his most recent posts are arguing that lower interest rates are contractionary per se.