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Liquidity, Information, and the Overnight Rate

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  • Christian Ewerhart
  • Nuno Cassola
  • Steen Ejerskov
  • Natacha Valla

Abstract

We model the interbank market for overnight credit with heterogeneous banks and asymmetric information. An unsophisticated bank just trades to compensate its liquidity imbalance, while a sophisticated bank will exploit its private information about the liquidity situation in the market. It is shown that with positive probability, the liquidity effect (Hamilton, 1997) is reversed, i.e., a liquidity drainage from the banking system may generate an overall decrease in the market rate. The phenomenon does not disappear when the number of banks increases. We also show that private information mitigates the effect of an unexpected liquidity shock on the market rate, suggesting a conservative information policy from a central bank perspective.

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Paper provided by Institute for Empirical Research in Economics - University of Zurich in its series IEW - Working Papers with number 186.

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Handle: RePEc:zur:iewwpx:186

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Keywords: Liquidity effect; asymmetric information; monetary policy implementation;

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  1. James D. Hamilton, 1996. "Measuring the liquidity effect," Working Papers in Applied Economic Theory 96-06, Federal Reserve Bank of San Francisco.
  2. Kyle, Albert S, 1985. "Continuous Auctions and Insider Trading," Econometrica, Econometric Society, vol. 53(6), pages 1315-35, November.
  3. Campbell, John, 1987. "Money Announcements, The Demand for Bank Reserves, and the Behavior of the Federal Funds Rate within the Statement Week," Scholarly Articles 3220231, Harvard University Department of Economics.
  4. Sanford J Grossman & Joseph E Stiglitz, 1997. "On the Impossibility of Informationally Efficient Markets," Levine's Working Paper Archive 1908, David K. Levine.
  5. Ho, Thomas S Y & Saunders, Anthony, 1985. " A Micro Model of the Federal Funds Market," Journal of Finance, American Finance Association, vol. 40(3), pages 977-88, July.
  6. Bhattacharya, Sudipto & Fulghieri, Paolo, 1994. "Uncertain liquidity and interbank contracting," Economics Letters, Elsevier, vol. 44(3), pages 287-294.
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Cited by:
  1. Bruno S. Frey & Simon Luechinger & Alois Stutzer, 2004. "Calculating Tragedy: Assessing the Costs of Terrorism," CESifo Working Paper Series 1341, CESifo Group Munich.
  2. Marius Jurgilas, 2006. "Interbank Markets under Currency Boards," Working papers 2006-19, University of Connecticut, Department of Economics.
  3. Moschitz, Julius, 2004. "The determinants of the overnight interest rate in the euro area," Working Paper Series 0393, European Central Bank.
  4. George Mountis, 2012. "Banks’ Domestic & Cross-border M&As: Where Can They Go Wrong?," Cyprus Economic Policy Review, University of Cyprus, Economics Research Centre, vol. 6(1), pages 39-67, June.
  5. Hałaj, Grzegorz & Kok, Christoffer, 2014. "Modeling emergence of the interbank networks," Working Paper Series 1646, European Central Bank.
  6. Schanz, Jochen, 2009. "How do different models of foreign exchange settlement influence the risks and benefits of global liquidity management?," Bank of England working papers 374, Bank of England.
  7. Marius Jurgilas, 2005. "Interbank market under the currency board: Case of Lithuania," Computing in Economics and Finance 2005 448, Society for Computational Economics.

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