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The payment of interest on reserves has been a common practice in inflationary economies. This policy may seem paradoxical since it involves returning part of the seigniorage, generated by the inflation process, with the intention to finance the fiscal deficit. This paper argues that the motivation for this policy can be captured by the discretionary regime, where the policymaker pays interest on reserves because he is concerned with the erosion of real liquidity by inflation, which is in part beyond his control. However, this policy is an unlikely outcome in the commitment regime, where the policymaker is in full control of inflation.

The high inflation equilibrium (HIE) refers to a steady state solution where inflation is higher than the one which maximizes seigniorage (i.e. inflation is on the falling segment of the Laffer curve). It has been claimed that the HIE can be stable when the adjustment of expectation is fast. However, adjustment is fast because inflation is high; so the argument is circular. In this paper we rationalize the HIE using the policy game approach which distinguishes between discretionary and precommitment regimes. We expand, and demonstrate rigorously (using a technique developed by Obstfeld), Barro's suggestion that a HIE may result from a discretionary regime. We show that this is not possible under precommitment. In addition, we demonstrate that a HIE may result from non-fiscal factors (such as the motivation to reduce unemployment) in a discretionary regime. We conclude with a simple diagrammatic exposition of the difference between our approach and the previous one.