Redemption Costs and Interest Rates under the U.S. National Banking System.

Interest rates under the U.S. National Banking System (1863-1914) appear to imply that banks failed to exploit an arbitrage opportunity for two reasons: Yields on government bonds exceeded the tax rate on note issue by approximately 150 basis points, and short-term interest rates varied seasonally. This paper examines whether note redemption costs can explain observed interest rates. We present a model in which redemption costs create a spread between the tax rate on note issue and bond yields and in which temporary seasonal fluctuations in currency demand generate seasonal movements in short-term interest rates. Calibration of the model to actual data lends support to the model's implications. Further, interest rates are shown not to vary seasonally when banks do not incur the costs of note redemption. [ABSTRACT FROM AUTHOR]