Surplus Liquidity: Implications for Central Banks

Surplus liquidity occurs where cashflows into the banking system persistently exceed withdrawals of liquidity from the market by the central bank. This is reflected in holdings of reserves in excess of the central bank's required reserves. The occurrence of surplus liquidity is widespread, covering many countries around the world. Historically, it has been observed most often in Soviet, wartime and transitional countries. Transitional economies, for example, often attract large capital inflows as the economy opens and undergoes privatisation. The effect of these inflows on liquidity is often magnified by central bank intervention in the foreign exchange market when there is upward pressure on the domestic currency. In the wartime economy, consumption is restricted and large amounts of involuntary savings accumulate until goods and services eventually become more widely available. Soviet-style economies have displayed widespread shortages and administered prices. This creates a situation of repressed inflation, whereby prices are too low relative to the money stock, leaving individuals with excess real balances. The importance of surplus liquidity for central banks is threefold and lies in its potential to influence: (1) the transmission mechanism of monetary policy; (2) the conduct of central bank intervention in the money market, and (3) the central bank's balance sheet and income.