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The liquidity effect for open market operations

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  • Kopchak, Seth J.

Abstract

The liquidity effect is the negative relationship between the supply of federal funds and the overnight federal funds rate. Deviations of the federal funds rate from its target can be interpreted as demand innovations for federal funds. Permanent adjustments to demand are modeled as an unobserved component and estimated using the Kalman filter to identify liquidity effects. The demand-based approach for identifying the liquidity effect contrasts previous work which concentrates on errors forecasting the supply of federal funds. This paper finds a liquidity effect several times larger than that from previous studies, indicating the market for federal funds is less liquid than previously thought. The effect of a $1 billion increase in open market operations over a 1-week period is a decrease of the federal funds rate by about 12 basis points.

Suggested Citation

  • Kopchak, Seth J., 2011. "The liquidity effect for open market operations," Journal of Banking & Finance, Elsevier, vol. 35(12), pages 3292-3299.
    • Handle: RePEc:eee:jbfina:v:35:y:2011:i:12:p:3292-3299
    DOI: 10.1016/j.jbankfin.2011.05.011
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    References listed on IDEAS

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    1. Judson, Ruth A. & Klee, Elizabeth, 2010. "Whither the liquidity effect: The impact of Federal Reserve open market operations in recent years," Journal of Macroeconomics, Elsevier, vol. 32(3), pages 713-731, September.
    2. Feinman, Joshua N, 1993. "Estimating the Open Market Desk's Daily Reaction Function," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 25(2), pages 231-247, May.
    3. Carpenter, Seth & Demiralp, Selva, 2006. "The Liquidity Effect in the Federal Funds Market: Evidence from Daily Open Market Operations," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 38(4), pages 901-920, June.
    4. Marc Nerlove, 1958. "Adaptive Expectations and Cobweb Phenomena," The Quarterly Journal of Economics, President and Fellows of Harvard College, vol. 72(2), pages 227-240.
    5. Hamilton, James D, 1997. "Measuring the Liquidity Effect," American Economic Review, American Economic Association, vol. 87(1), pages 80-97, March.
    6. Daniel L. Thornton, 2006. "The daily liquidity effect," Working Papers 2006-020, Federal Reserve Bank of St. Louis.
    7. anonymous, 2004. "Domestic open market operations during 2004," Annual Report Domestic Open Market Operations, Federal Reserve Bank of New York.
    8. Seth Carpenter & Selva Demiralp, 2008. "The Liquidity Effect in the Federal Funds Market: Evidence at the Monthly Frequency," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 40(1), pages 1-24, February.
    9. Daniel L. Thornton, 2001. "Identifying the liquidity effect at the daily frequency," Review, Federal Reserve Bank of St. Louis, vol. 83(Jul), pages 59-82.
    10. Klee, Elizabeth, 2010. "Operational outages and aggregate uncertainty in the federal funds market," Journal of Banking & Finance, Elsevier, vol. 34(10), pages 2386-2402, October.
    11. Daniel L. Thornton, 2007. "Open market operations and the federal funds rate," Review, Federal Reserve Bank of St. Louis, vol. 89(Nov), pages 549-570.
    12. Simon Gilchrist, 2001. "Identifying the liquidity effect at the daily frequency (commentary)," Review, Federal Reserve Bank of St. Louis, vol. 83(Jul), pages 59-82.
    13. Thornton, Daniel L., 2004. "The Fed and short-term rates: Is it open market operations, open mouth operations or interest rate smoothing?," Journal of Banking & Finance, Elsevier, vol. 28(3), pages 475-498, March.
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    Cited by:

    1. Dawid J. van Lill, 2017. "Changes in the Liquidity Effect Over Time: Evidence from Four Monetary Policy Regimes," Working Papers 704, Economic Research Southern Africa.
    2. Narayan Bulusu, 2020. "Why Do Central Banks Make Public Announcements of Open Market Operations?," Staff Working Papers 20-35, Bank of Canada.
    3. Antonis Michis, 2011. "Multiscale Analysis of the Liquidity Effect," Working Papers 2011-5, Central Bank of Cyprus.
    4. Antonis Michis, 2015. "Multiscale Analysis of the Liquidity Effect in the UK Economy," Computational Economics, Springer;Society for Computational Economics, vol. 45(4), pages 615-633, April.
    5. Marquez, Jaime & Morse, Ari & Schlusche, Bernd, 2013. "The Federal Reserve’s balance sheet and overnight interest rates: Empirical modeling of exit strategies," Journal of Banking & Finance, Elsevier, vol. 37(12), pages 5300-5315.
    6. Jaime R. Marquez & Ari Morse & Bernd Schlusche, 2012. "The Federal Reserve's balance sheet and overnight interest rates," Finance and Economics Discussion Series 2012-66, Board of Governors of the Federal Reserve System (U.S.).
    7. Zheng Qiao & Yangshu Liu, 2017. "Open Market Operation Effectiveness in China," Emerging Markets Finance and Trade, Taylor & Francis Journals, vol. 53(8), pages 1706-1719, August.

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    More about this item

    Keywords

    Liquidity effect; Open market operations; Federal funds rate;
    All these keywords.

    JEL classification:

    • E5 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit
    • E58 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Central Banks and Their Policies
    • E43 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Interest Rates: Determination, Term Structure, and Effects

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