Answer to Question #110738 in Macroeconomics for Anesia Lalloo

Question

Explain, with aid of diagrams, the anticipated transmission mechanism thatcan result from a simultaneous reduction in the reserve requirement and the repo rate.

Answer 1

Increased efforts to better control short-term interest rates may initially increase central bank costs in cases of particular large excess reserves. Banks have strong incentives to hoard reserve balances when liquidity risks are particular high because of a non-functioning inter-bank market, excessive high-frequency inter-bank rate volatility and low market liquidity, large spreads between central bank lending rates and market rates, and/or  constraints on access to central bank lending facilities. In such a situation, banks may need to hold substantially larger excess reserve balances than what they would need in a better functioning system. Consequently, there may be a need for fairly large and costly mopping up operations to keep market rates close to the target as the operating framework is improved. Increasing unremunerated reserve requirements, shifting government accounts from commercial banks to the central bank, and/or increased issuance of government debt with the proceeds placed in a locked government account at the central bank could be used to more permanently mop up this structural excess liquidity and reduce the costs to the central bank of operating a better functioning monetary policy framework.