Interbank Market Liquidity and Central Bank Intervention
Title: Interbank Market Liquidity and Central Bank Intervention
Series/Report no.: EUI ECO; 2009/09
We develop a simple model of the interbank market where banks trade a long term, safe asset. We show that when there is a lack of opportunities for banks to hedge aggregate and idiosyncratic liquidity shocks, the interbank market is characterized by excessive price volatility. In such a situation, a central bank can implement the constrained efficient allocation by using open market operations to fix the short term interest rate. The model shows also that market freezes, where banks stop trading with each other, can be a feature of the constrained efficient allocation if there is sufficient uncertainty about aggregate liquidity demand compared to idiosyncratic liquidity demand.
Subject: interbank market; liquidity; central bank intervention; open market operations; G01; G18; G21
Type of Access: openAccess