Abstract
This paper analyzes the role of standing facilities in the determination of the demand for reserves in the overnight money market. The paper shows how central banks could use the position of the main refinancing rate with respect to the deposit and lending rates as a policy tool to control the demand for excess reserves by depository institutions. Furthermore, it illustrates how the existence of fine-tuning operations at the end of the reserve maintenance period significantly affects the ability of the central bank to influence the demand for reserves.
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Notes
As defined by the ECB, a fine-tuning operation is a nonregular open market operation executed mainly to deal with unexpected liquidity fluctuations in the market.
See also Baltensperger (1980) for a survey and references to the early literature on this subject.
Bindseil and Jablecki (2011b) document the observed positive relation between the width of the corridor and the volatility of overnight market rates.
See Bindseil and Jablecki (2011a) for a review of the merits of an active interbank market.
Throughout the paper we will use indistinctly, the terms “depository institutions,” “commercial banks,” or “banks,” for short.
For the euro area the variable shown is the use of the deposit facility.
This value was reached on September 9, 2008 which was the end of a reserve maintenance period.
On June 25, 2009, the ECB started conducting liquidity-providing main refinancing operations with a year maturity. The larger use of the deposit facilities could be because of expectations of future rate increases.
Effective December 16, 2008, the U.S. Federal Reserve started to report its target rate as a range. From that date we used the rate paid on excess reserve balances as a reference for the federal funds rate.
Notice floor systems can be seen as a particular case of corridor systems in which central banks flood the market with reserves so as to push market rates to the lower edge of the band.
We make this assumption for simplicity but capitalization of interests only has a second-order effect and will not affect the results below significantly.
The reader should remember that trading in the market is done with an overnight maturity. This means that the intertemporal evolution of reserves for an individual bank does not depend on the decision made about m t j or b t j but only on the realization of the shock ɛ t j.
In what follows, capital letters refer to aggregate variables.
Computations are done in the Appendix.
This expression assumes an interior solution. If b̂ 2 j represents the solution of that expression, the decision on supply of funds have to satisfy b 2 j=min[b̂ 2 j, max(0, a 2 j)].
Remember we are conditioning on the event of an aggregate liquidity shortage so that the fine-tuning operation is liquidity providing.
Expressions of this sort, by which the rate of the open market operation equals the expected average of market rates throughout the reserve maintenance period, are a typical result in this literature. See, among others, Valimaki (2003).
See the Appendix for a proof of this statement.
Intuitively, this level should coincide with the middle of the corridor. However, as Pérez Quirós and Rodríguez Mendizábal (2006) show, the probabilities of ending the maintenance period with an excess or shortage of reserves are not symmetric. This is because being locked-in is an absorbing state while having a reserve shortage is not. The slight move of the elastic part to the upper side of the corridor is a consequence of this result.
References
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Additional information
*Gabriel Perez Quiros has a PhD in Economics from the University of California, San Diego. He is Unit Head of Macroeconomic Research at the Bank of Spain. He previously worked at the Federal Reserve Bank of New York, the European Central Bank and the Economic Bureau of the Spanish Prime Minister. Hugo Rodriguez Mendizabal holds a PhD in Economics from the university of Chicago. Currently, he is Tenured Scientist at the Institute for Economic Analysis, CSIC and Affiliated Professor at the Barcelona GSE. The authors thank Juan Ayuso, Roberto Blanco, José Manuel Marqués, Arturo Mesón, an anonymous referee of the Working Paper series at the Bank of Spain, and participants at the internal seminar of the Bank of Spain for helpful suggestions. They also appreciate very valuable comments from the editor, Pierre-Olivier Gourinchas, and two anonymous referees. Rodríguez Mendizábal acknowledges the financial support of the Spanish Ministry of Science and Innovation through grant ECO 2009-07958, of the Barcelona GSE Research Network and of the Government of Catalonia.
Appendix
Appendix
A.I. Analytical Derivations in the Paper
Expected profits at period t=2, can be derived, when there is an aggregate liquidity shortage, A 2−R 2<0, substituting Equations (1) and (6) in Equation (7). This yields the expression
Taking derivatives with respect to b 2 j produces the first-order condition (8). The rest of the cases are handled similarly.
In addition, for period t=1, using Equation (1) and taking expectations produces the expected value of profits
To compute the second term in Equation (17), we make use of the distribution of r 2 j. Then,
Furthermore, using Equations (8), (11), (14), and (19), we can see how the demand for reserves at the OMO is independent of the spread between the lending and deposit rates. From Equations (8), (11), and (14), we can write, respectively,
where both A 2 and R 2 depend on A 1 and are defined in Equations (4) and (5), respectively. On the other hand, from Equation (19), we can write
Define the asymmetry coefficient of the interest rate corridor as
From Equations (22), (A.1), (A.2), (A.3), and (A.4), it is easy to see that the demand for funds at the initial OMO, A 1, that satisfies Equation (22) only depends on α and not on the spread (i l−i d). For that, take Equation (24)
From Equation (A.4)
But from Equations (A.1), (A.2), and (A.3), we have respectively that
Thus, all these equations are independent of the spread (i l−i d) so that the only variable that matters is the asymmetry index α.