Money market volatility

This paper analyses different operational central bank policies and their impact on the behaviour of the money market interest rate. The model combines profit maximising behaviour by commercial banks with the central bank supplying the liquidity that keeps the market rate on target. It seems that frequent liquidity supplying operations represent an efficient tool to control money market rates. An averaging provision reduces the use of standing facilities and interest rates volatility in all days except for the last day of the maintenance period. Whenever banks have different maintenance horizons both the spikes in volatility and use of standing facilities disappear. The paper also compares two different liquidity supply policies and finds that the level of liquidity necessary to keep the rates on target depends on not only the aggregate but also assets values of individual banks.

Introduction: The view that the centralbank(CB)exertsaninfluence over the economy by using interest rates as a direct tool has now been widely accepted for some time. The exact mechanism of control over the interest rate, or so called the operational policy has however attracted much less attention and very often is taken for granted. This particular research niche has recently seen some revived interest resulting in a series of publications; many questions however remain still open. The operational policy targets the level and volatility of the interbank\ market interest rates, and basic instruments at the CB disposal include:an obligatory reserve requirement, open market operations (OMO) and lending/deposit facility. So far no golden rule for the effective operational policy mix has been found. Indeed, countries over the world have decided in favour of very different setups and none of them can claim perfect control, even though all are successful in setting the rates on target level in the long term.

Author: Michal Kempa

Source: Research Discussion Papers, Bank of Finland

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