Reserves, Liquidity and Money : An Assessment of Balance Sheet Policies

The financial crisis and its aftermath have stimulated a vigorous debate on the use of macroprudential instruments both for regulating the banking system and for providing additional tools for monetary policymakers. The widespread adoption of non-conventional monetary policies has provided some evidence on the efficacy of liquidity and asset purchases for offsetting the zero lower bound. Central banks have thus been put in mind of the effectiveness of extended open market operations as supplementary monetary policy tools. These are essentially fiscal instruments, in that they entail the issuance of central bank liabilities backed by fiscal transfers. Given that these tools are written into fiscal budget constraints, we can examine the consequences of the operations in the context of a microfounded macroeconomic model of banking and money, and we can simulate the responses of the Federal Reserve balance sheet to the crisis. Specifically, we examine the role that reserves for bond and capital swaps play in stabilizing the economy, as well as the impact of changes in the composition of the central bank balance sheet. We find that such policies can significantly enhance the ability of the central bank to stabilize the economy. This is because balance sheet operations supply (remove) liquidity to a financial market that is otherwise short (long) of liquidity, and hence allow other financial spreads to move less violently over the cycle to compensate.Full publication: "http://ssrn.com/abstract=2166373" Are Central Bank Balance Sheets in Asia Too Large?