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The liquidity effect for open market operations

  • Kopchak, Seth J.

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.

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Article provided by Elsevier in its journal Journal of Banking & Finance.

Volume (Year): 35 (2011)
Issue (Month): 12 ()
Pages: 3292-3299

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Handle: RePEc:eee:jbfina:v:35:y:2011:i:12:p:3292-3299
Contact details of provider: Web page: http://www.elsevier.com/locate/jbf

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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. Daniel L. Thornton, 2007. "Open market operations and the federal funds rate," Review, Federal Reserve Bank of St. Louis, issue Nov, pages 549-570.
  3. 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.
  4. 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, 02.
  5. Hamilton, James D, 1997. "Measuring the Liquidity Effect," American Economic Review, American Economic Association, vol. 87(1), pages 80-97, March.
  6. anonymous, 2004. "Domestic open market operations during 2004," Annual Report Domestic Open Market Operations, Federal Reserve Bank of New York.
  7. 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.
  8. 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.
  9. Simon Gilchrist, 2001. "Identifying the liquidity effect at the daily frequency (commentary)," Review, Federal Reserve Bank of St. Louis, issue Jul, pages 59-82.
  10. Daniel L. Thornton, 2001. "Identifying the liquidity effect at the daily frequency," Review, Federal Reserve Bank of St. Louis, issue Jul, pages 59-82.
  11. Daniel L. Thornton, 2006. "The daily liquidity effect," Working Papers 2006-020, Federal Reserve Bank of St. Louis.
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