Ebook Surplus Liquidity: Implications for Central Banks
Surplus reserves in the banking system are common in countries across the world. They arise where the banks’ working balances on accounts at the central bank persistently exceed the required level of reserves. In other words, surplus liquidity occurs where cash flows into the market for reserves continuously exceed cash flows drained into the central bank. This can occur in any economy, but, historically, Soviet, wartime and transitional countries have been among the most prone to liquidity surpluses. Transitional economies, for example, often attract large capital inflows as the economy opens and undergoes privatisation. In the wartime economy, consumption is restricted and large amounts of involuntary savings accumulate until goods and services eventually become more widely available. Soviet-style economies have displayed widespread shortages and administered prices. This creates a situation of repressed inflation, whereby prices are too low relative to the money stock, leaving individuals with excess real balances. Clearly, the incidence of surplus liquidity is wide and may have important implications for both central bank policy and operations.
The objective of the paper is to define carefully the way in which surplus liquidity arises, how far in practice this represents a problem for central banks and, if so, what the possible responses might be.
The potential issues raised by surplus liquidity are threefold and concern:
- The transmission mechanism of monetary policy;
- The conduct of central bank intervention in the money market;
- The central bank’s balance sheet and income.
Section 2 begins by considering the choices which determine the desired level of cash balances and how these can influence the transmission mechanism of monetary policy. Empirically, the main source of surplus reserves in recent years has been capital inflows of one sort or another, usually in the form of foreign direct investment or aid and often into countries with fixed exchange rate regimes. The objective of section 3 is to discuss these underlying sources of liquidity and to illustrate them in terms of actual country experience. Sections 4 and 5 move on to cover the workings of the central bank balance sheet, and, in particular, the main factors in the supply and demand for central bank reserves. A thorough appreciation of the central bank balance sheet is fundamental to an understanding of surplus reserves.
Central bank reserves are defined for practical purposes as domestic deposits held at the central bank by its main counterparties; and the “banking system” (or, more widely, the “market”) is taken to include all financial institutions that have access to central bank credit or which operate an account with the central bank. Section 6 discusses concepts of market balance and examines the effectiveness of central bank intervention in the presence of surplus liquidity. Section 7 outlines the main approaches to the sterilisation of surpluses and the costs that these may bring. Section 8 summarises the main themes.
Contents
Abstract
1. Introduction
2. Liquidity Choices and Monetary Policy
- 2.1. Microfoundations
2.2. The Transmission Mechanism and Surplus Liquidity
3. The Main Sources of Surplus Liquidity
- 3.1. Current Account Balance and the Exchange Rate
3.2. Capital Account Flows
3.3. IMF Credits and Aid
3.4. Lending to Government
3.5. Financial Infrastructure and Market Forces
3.6. Currency Boards and Liquidity
4. Supply of Central Bank Reserves
- 4.1. Net Foreign Assets
4.2. Net Lending to Government
4.3. Cash in Circulation
4.4. Other Items
4.5. Net Market Lending
5. Demand for Central Bank Reserves
- 5.1. Required Reserves
5.2. Free Reserves
5.3. Payments Technology
5.4. Central Bank Credit and the Incentive Structure
6. Liquidity Balance and Monetary Policy Implementation
- 6.1. Market Balance Concepts
6.2. Monetary Policy Implementation
7. Sterilisation of Surplus Liquidity
- 7.1. Market-based Remedies
7.2. Auctions of Assets and Liabilities
7.3. Costs and Benefits of Liquidity Sterilisation
7.4. Non-market remedies
8. Summary
9. References
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