Is There a Liquidity Effect in the Japanese Market?

This paper examines whether there is a liquidity effect in the Japanese interbank market for overnight loans. If the reserve requirement is the only reason for banks to hold reserves, then the demand for reserves should be infinitely elastic at the overnight rate that is expected to prevail for the rest of the reserve maintenance period. If, however, reserves are also useful for facilitating transactions between banks, then the demand curve will be down-sloping as a function of the overnight rate. We say that a liquidity effect exists if the demand curve is downward sloping, not horizontal, at the observed level of reserves. Estimating the slope of the demand curve for reserves must deal with the simultaneity problem because the central bank actively chooses the supply of reserves to guide the overnight rate to a range close to the target rate. This paper estimates the liquidity effect in the Japanese interbank market for overnight loans (the so-called Call market). The estimation exploits the institutional features, particularly the fact that the rates observed in the morning are forward rates for funds deliverable at 1 pm of the day. The results indicate that the large injection of reserves by the Bank of Japan after the Yamaichi debacle was not enough to eliminate the liquidity effect. The evidence found in this paper is consistent with the view that the Desk behaved optimally before and after the Yamachi debacle.