Central Bank Debt Purchases: Impact on Monetary Policy

Does the Purchase of Government Debt by Monetary Authorities Enhance Macroeconomic Policy?

Yes, this is actually what happened in the aftermath of the financial crisis that led central banks (CBs) to buy large amounts of public debt. The explanation is as follows:

Impact of Central Bank Debt Purchases on Liquidity

When the CB buys a large amount of government debt, it implies a higher volume of liquidity injected into the economy. Once the volume of liquidity is such that the interest rate market hits the lower bound of the corridor (deposit rate), further injection of liquidity (quantity) allows them to also control the interest rate (price). The internal market will not fall further as the CB dominates all other aspects of the economy, and the interest rate in the internal market will not surpass the deposit rate (who will borrow money from other banks when they could be granted a loan from the CB at a lower rate?). That is why the deposit rate is a lower bound. When we hit this deposit rate, it means that the CB can adjust the interest rate and deposit rate. This situation is also known as a floor system.

The Floor System and Central Bank Control

Once we hit the lower bound of the corridor, it is a wonderland for monetary policy: the CB can set the interest rate and volume of liquidity simultaneously, gaining a new degree of freedom. Before, the CB was thought to only control the monetary base (quantity) or interest rate (price), and not both at the same time.

A floor system allows the CB to divorce the quantity of reserves from the interest rate target, gaining one degree of freedom as it is now able to set both the interest rate and the volume of liquidity. That is why after the crisis most CBs adopted the floor system (before, only New Zealand and Norway did it). This is the reason why after the crisis, EONIA stayed close to the deposit rate (narrowed corridor).

Preconditions for Enhanced Monetary Policy

But as we mentioned, this strategy is only applicable if the CB has previously put in place institutional innovations (such as a minimum reserve system) and put in place a corridor with an upper bound = rate of the marginal lending facility and a lower bound = deposit rate. This structure is the condition that allows the CB to gain one degree of freedom by pushing the interest rate market to the lower bound (deposit rate) by injecting a large amount of liquidity (buying a large amount of public debt, for example), allowing it to control both the interest and volume of liquidity. Basically, a 'floor system' is a variant of an interest rate corridor regime with an adjustable floor.