Central Bank Standing Facilities and Liquidity Traps
Central Bank Mechanisms and Standing Facilities
The following explains how the implementation by Central Banks of institutional mechanisms, such as standing facilities, functions within the economy.
Standing Facilities and Volatility Control
The standing facilities allow the Central Bank (CB) to control volatility and provide the framework to gain a degree of freedom in the conduct of monetary policy. The rate on the marginal lending facility and the rate on the deposit facility provide a ceiling and a floor, respectively, for the overnight rate in the money market.
By setting the rates of the standing facilities, the Governing Council determines the corridor within which the overnight money market rate can fluctuate, thus restricting the volatility of short-term interest rates in the money market. This corridor is characterized by having:
- An upper bound (ceiling) = marginal interest rate
- A lower bound (floor) = deposit rate
Minimum Reserve Requirements and Averaging
The minimum reserve requirement system and the averaging procedure allow the CB to intervene less frequently in the money market. The first key function of the minimum reserve system is to stabilize money market interest rates. This function is performed by the averaging provision.
The averaging provision also allows credit institutions to smooth out daily liquidity fluctuations (e.g., those arising from fluctuations in the demand for banknotes), since transitory reserve imbalances can be offset by opposite reserve imbalances generated within the same maintenance period.
The averaging provision implies that institutions can profit from lending in the market and run a reserve deficit whenever the shortest money market rates are above those expected to prevail for the remainder of the maintenance period. In the opposite scenario, they can borrow in the market and run a reserve surplus.
In theory, this "inter-temporal arbitrage" should ensure equality throughout the maintenance period between the current level of the shortest money market rates and their expected level at the end of the maintenance period. Thus, this mechanism stabilizes the overnight interest rate during the maintenance period and makes it unnecessary for the CB to intervene frequently in the money market.
The Concept of the Liquidity Trap
A liquidity trap (LT) is defined as a situation in which the real interest rate—at which savings at the employment rate consistent with constant inflation and investment would be equal—cannot be achieved.
Omega (ω) is the minimum current real interest rate that a CB can set for a given set of inflation expectations. A liquidity trap is a situation in which the neutral interest rate falls to omega. Omega takes into account the existence of a lower bound equal to zero for the interest rate.