Interbank Markets under Currency Boards Marius Jurgilas University - - PowerPoint PPT Presentation

Interbank Markets under Currency Boards

Marius Jurgilas

University of Connecticut

August 2007

Marius Jurgilas (University of Connecticut) Interbank Markets under Currency Boards August 2007 1 / 29

Outline

1

Introduction

2

Institutional structure of interbank markets under currency boards

3

Liquidity effect under a currency board Motivation Data and Methodology Results

4

Reserve management under a currency board Motivation Model Results

5

Monetary policy under a currency board Motivation Model Results

6

Conclusion

Marius Jurgilas (University of Connecticut) Interbank Markets under Currency Boards August 2007 2 / 29

Introduction

Definitions

Interbank market Market for unsecured short period (overnight) loans or “reserves market”. Bank reserve management Liquidity for day-to-day activities Minimum reserve requirement Currency board Specific type of a fixed exchange rate regime. Fully backed liabilities of the central bank Exchange of funds to/from the base currency

Marius Jurgilas (University of Connecticut) Interbank Markets under Currency Boards August 2007 3 / 29

Introduction

Definitions

Interbank market Market for unsecured short period (overnight) loans or “reserves market”. Bank reserve management Liquidity for day-to-day activities Minimum reserve requirement Currency board Specific type of a fixed exchange rate regime. Fully backed liabilities of the central bank Exchange of funds to/from the base currency

Marius Jurgilas (University of Connecticut) Interbank Markets under Currency Boards August 2007 3 / 29

Institutional structure of interbank markets under currency boards

First essay: Institutional structure of interbank markets under currency boards

No activist monetary policy Convergence of interest rates Required reserves Government’s bank

Marius Jurgilas (University of Connecticut) Interbank Markets under Currency Boards August 2007 4 / 29

Institutional structure of interbank markets under currency boards

Bulgaria

Figure: Interbank interest rates in Bulgaria

Marius Jurgilas (University of Connecticut) Interbank Markets under Currency Boards August 2007 5 / 29

Institutional structure of interbank markets under currency boards

Lithuania

Figure: Interbank interest rates in Lithuania

Marius Jurgilas (University of Connecticut) Interbank Markets under Currency Boards August 2007 6 / 29

Liquidity effect under a currency board Motivation

Second essay: Liquidity effect under a currency board

Motivation: Ongoing debate on the existence of the liquidity effect in the literature (Hamilton (1996), Thornton (2001), Carpenter and Demiralp (2006), Thornton (2006)) Questions:

1 Do exogenous changes in aggregate liquidity affect interest rate: is

there a “liquidity effect”?

2 Should we observe constant interest rates in case of efficient

interbank market? Why currency board countries? Central banks do not intervene in reserves market Phenomenon of decreasing interest rates towards the end of the reserve holding period

Marius Jurgilas (University of Connecticut) Interbank Markets under Currency Boards August 2007 7 / 29

Liquidity effect under a currency board Motivation

Second essay: Liquidity effect under a currency board

Motivation: Ongoing debate on the existence of the liquidity effect in the literature (Hamilton (1996), Thornton (2001), Carpenter and Demiralp (2006), Thornton (2006)) Questions:

1 Do exogenous changes in aggregate liquidity affect interest rate: is

there a “liquidity effect”?

2 Should we observe constant interest rates in case of efficient

interbank market? Why currency board countries? Central banks do not intervene in reserves market Phenomenon of decreasing interest rates towards the end of the reserve holding period

Marius Jurgilas (University of Connecticut) Interbank Markets under Currency Boards August 2007 7 / 29

Liquidity effect under a currency board Motivation

Second essay: Liquidity effect under a currency board

Motivation: Ongoing debate on the existence of the liquidity effect in the literature (Hamilton (1996), Thornton (2001), Carpenter and Demiralp (2006), Thornton (2006)) Questions:

1 Do exogenous changes in aggregate liquidity affect interest rate: is

there a “liquidity effect”?

2 Should we observe constant interest rates in case of efficient

interbank market? Why currency board countries? Central banks do not intervene in reserves market Phenomenon of decreasing interest rates towards the end of the reserve holding period

Marius Jurgilas (University of Connecticut) Interbank Markets under Currency Boards August 2007 7 / 29

Liquidity effect under a currency board Data and Methodology

Data and Methodology

Aggregate interbank market data for Bulgaria and Lithuania Lithuania: 2002:02-2005:12 (990 daily observations) Bulgaria: 2002:01-2006:04 (1041 daily observations) Estimating EGARCH(γ, q) model of the following form: rt = µt + ht ǫt where µt = rt−1 + b′ Xt ǫt ∼ p N[0, 1] + (1 − p) N[0, σ2] and ln ht = λ′ Vt +

q

• j=1

dj1 (ln ht−1 − λ′ Vt−1) + +

p

• i=1

di2 ǫt−1

• ht−1

+ di3 ( |ǫt−1|

• ht−1

−

• 2

π)

Marius Jurgilas (University of Connecticut) Interbank Markets under Currency Boards August 2007 8 / 29

Liquidity effect under a currency board Data and Methodology

Data and Methodology

Aggregate interbank market data for Bulgaria and Lithuania Lithuania: 2002:02-2005:12 (990 daily observations) Bulgaria: 2002:01-2006:04 (1041 daily observations) Estimating EGARCH(γ, q) model of the following form: rt = µt + ht ǫt where µt = rt−1 + b′ Xt ǫt ∼ p N[0, 1] + (1 − p) N[0, σ2] and ln ht = λ′ Vt +

q

• j=1

dj1 (ln ht−1 − λ′ Vt−1) + +

p

• i=1

di2 ǫt−1

• ht−1

+ di3 ( |ǫt−1|

• ht−1

−

• 2

π)

Marius Jurgilas (University of Connecticut) Interbank Markets under Currency Boards August 2007 8 / 29

Liquidity effect under a currency board Results

Empirical Results

Do exogenous changes in aggregate liquidity affect interest rate: is there a “liquidity effect”? No liquidity effect Do we observe constant interest rates? Decreasing interest rates Other results: Interest rates increase with the aggregate reserve deficiency Higher aggregate deficiency is associated with falling interest rates towards the end of the reserve holding period Variability of interest rates decreases with a decrease in the foreign exchange fee

Marius Jurgilas (University of Connecticut) Interbank Markets under Currency Boards August 2007 9 / 29

Liquidity effect under a currency board Results

Empirical Results

Do exogenous changes in aggregate liquidity affect interest rate: is there a “liquidity effect”? No liquidity effect Do we observe constant interest rates? Decreasing interest rates Other results: Interest rates increase with the aggregate reserve deficiency Higher aggregate deficiency is associated with falling interest rates towards the end of the reserve holding period Variability of interest rates decreases with a decrease in the foreign exchange fee

Marius Jurgilas (University of Connecticut) Interbank Markets under Currency Boards August 2007 9 / 29

Liquidity effect under a currency board Results

Empirical Results

Do exogenous changes in aggregate liquidity affect interest rate: is there a “liquidity effect”? No liquidity effect Do we observe constant interest rates? Decreasing interest rates Other results: Interest rates increase with the aggregate reserve deficiency Higher aggregate deficiency is associated with falling interest rates towards the end of the reserve holding period Variability of interest rates decreases with a decrease in the foreign exchange fee

Marius Jurgilas (University of Connecticut) Interbank Markets under Currency Boards August 2007 9 / 29

Liquidity effect under a currency board Results

Empirical Results

Do exogenous changes in aggregate liquidity affect interest rate: is there a “liquidity effect”? No liquidity effect Do we observe constant interest rates? Decreasing interest rates Other results: Interest rates increase with the aggregate reserve deficiency Higher aggregate deficiency is associated with falling interest rates towards the end of the reserve holding period Variability of interest rates decreases with a decrease in the foreign exchange fee

Marius Jurgilas (University of Connecticut) Interbank Markets under Currency Boards August 2007 9 / 29

Reserve management under a currency board Motivation

Third essay: Reserve Management under a currency board

Provide a theoretical explanation for decreasing interest rates Gaspar et al. (2004) and Quir´

• s and Mendiz´

abal (2006): interest rates should be increasing. This paper: there are circumstances under which interest rates are decreasing.

Marius Jurgilas (University of Connecticut) Interbank Markets under Currency Boards August 2007 10 / 29

Reserve management under a currency board Motivation

Third essay: Reserve Management under a currency board

Provide a theoretical explanation for decreasing interest rates Gaspar et al. (2004) and Quir´

• s and Mendiz´

abal (2006): interest rates should be increasing. This paper: there are circumstances under which interest rates are decreasing.

Marius Jurgilas (University of Connecticut) Interbank Markets under Currency Boards August 2007 10 / 29

Reserve management under a currency board Motivation

Third essay: Reserve Management under a currency board

Provide a theoretical explanation for decreasing interest rates Gaspar et al. (2004) and Quir´

• s and Mendiz´

abal (2006): interest rates should be increasing. This paper: there are circumstances under which interest rates are decreasing.

Marius Jurgilas (University of Connecticut) Interbank Markets under Currency Boards August 2007 10 / 29

Reserve management under a currency board Model

Model Formulation

Stochastic general equilibrium model with heterogeneous agents in case of finite horizon: Following Gaspar et al. (2004) and Quir´

• s and Mendiz´

abal (2006): Infinite number of banks Each bank is required to maintain required reserves Two liquidity shocks: afternoon, evening (after the market is closed).

Marius Jurgilas (University of Connecticut) Interbank Markets under Currency Boards August 2007 11 / 29

Reserve management under a currency board Model

Model Formulation

Stochastic general equilibrium model with heterogeneous agents in case of finite horizon: Following Gaspar et al. (2004) and Quir´

• s and Mendiz´

abal (2006): Infinite number of banks Each bank is required to maintain required reserves Two liquidity shocks: afternoon, evening (after the market is closed).

Marius Jurgilas (University of Connecticut) Interbank Markets under Currency Boards August 2007 11 / 29

Reserve management under a currency board Model

Model Formulation

Stochastic general equilibrium model with heterogeneous agents in case of finite horizon: Following Gaspar et al. (2004) and Quir´

• s and Mendiz´

abal (2006): Infinite number of banks Each bank is required to maintain required reserves Two liquidity shocks: afternoon, evening (after the market is closed).

Marius Jurgilas (University of Connecticut) Interbank Markets under Currency Boards August 2007 11 / 29

Reserve management under a currency board Model

Model Formulation

Observe afternoon shock → lend/borrow in the domestic reserves market Under the currency board banks can utilize the foreign exchange window at the central bank and participate in the foreign reserves market. Banks are bound by minimum reserves and nonnegative end-of-the-day balance requirements End of the day balance is uncertain due to the evening shock In case of a violation of either condition the bank is forced to take a loan from the central bank at a penalty rate

Marius Jurgilas (University of Connecticut) Interbank Markets under Currency Boards August 2007 12 / 29

Reserve management under a currency board Model

Model Formulation

Observe afternoon shock → lend/borrow in the domestic reserves market Under the currency board banks can utilize the foreign exchange window at the central bank and participate in the foreign reserves market. Banks are bound by minimum reserves and nonnegative end-of-the-day balance requirements End of the day balance is uncertain due to the evening shock In case of a violation of either condition the bank is forced to take a loan from the central bank at a penalty rate

Marius Jurgilas (University of Connecticut) Interbank Markets under Currency Boards August 2007 12 / 29

Reserve management under a currency board Model

Model Formulation

Observe afternoon shock → lend/borrow in the domestic reserves market Under the currency board banks can utilize the foreign exchange window at the central bank and participate in the foreign reserves market. Banks are bound by minimum reserves and nonnegative end-of-the-day balance requirements End of the day balance is uncertain due to the evening shock In case of a violation of either condition the bank is forced to take a loan from the central bank at a penalty rate

Marius Jurgilas (University of Connecticut) Interbank Markets under Currency Boards August 2007 12 / 29

Reserve management under a currency board Model

Model Formulation

Observe afternoon shock → lend/borrow in the domestic reserves market Under the currency board banks can utilize the foreign exchange window at the central bank and participate in the foreign reserves market. Banks are bound by minimum reserves and nonnegative end-of-the-day balance requirements End of the day balance is uncertain due to the evening shock In case of a violation of either condition the bank is forced to take a loan from the central bank at a penalty rate

Marius Jurgilas (University of Connecticut) Interbank Markets under Currency Boards August 2007 12 / 29

Reserve management under a currency board Model

Model Formulation

Observe afternoon shock → lend/borrow in the domestic reserves market Under the currency board banks can utilize the foreign exchange window at the central bank and participate in the foreign reserves market. Banks are bound by minimum reserves and nonnegative end-of-the-day balance requirements End of the day balance is uncertain due to the evening shock In case of a violation of either condition the bank is forced to take a loan from the central bank at a penalty rate

Marius Jurgilas (University of Connecticut) Interbank Markets under Currency Boards August 2007 12 / 29

Reserve management under a currency board Model

Model Formulation

Interest rate wedge: ˆ ıt = ı∗

t ± f

No bank will deposit abroad if ıt > ˆ ıt and no bank will borrow abroad if ıt < ˆ ıt

Figure: Interbank market under the currency board

Marius Jurgilas (University of Connecticut) Interbank Markets under Currency Boards August 2007 13 / 29

Reserve management under a currency board Model

Vt(st, ft(st)) = max

lt,lft

• ıtlt + ˆ

ıtlft − E

εt

ct + E

{εt,λt+1}

Vt+1 (st+1, ft+1(st))

• for t < T

VT (sT , fT (sT )) = max

lT ,lfT

• ıT lT + ˆ

ıT lfT − E

εT

cT

• s.t. ct = −I(aet < 0)aetıcb, if t < T

cT = I(aeT < dT )(dT − aeT )ıcb where st = (at, dt) at+1 = at + λt + εt dt+1 = max(0, dt − max(0, aet)) aet = at − lt − lft + λt + εt ˆ ıt = ı∗

t + f , if borrowing in the foreign market

ˆ ıt = ı∗

t − f , if lending in the foreign market

ıcb = penalty rate at the central bank t = 1...T ft(st) = the distribution of banks across different states

Marius Jurgilas (University of Connecticut) Interbank Markets under Currency Boards August 2007 14 / 29

Reserve management under a currency board Model

Numerical Simulation

(a) b1 = 21, d1 = 211 (b) b1 = 21, d1 = 210 (c) b1 = 21, d1 = 209

Figure: Equilibrium interest rates within the reserve holding period

Marius Jurgilas (University of Connecticut) Interbank Markets under Currency Boards August 2007 15 / 29

Reserve management under a currency board Results

Results

Quir´

• s and Mendiz´

abal (2006): interest rates should be increasing. Intuition: “Probability of going to the deposit facility should be increasing over time”. This paper: Interest rates can be decreasing or increasing Intuition: Probability of not meeting the reserve requirement is increasing or decreasing depending on the aggregate availability of funds.

Marius Jurgilas (University of Connecticut) Interbank Markets under Currency Boards August 2007 16 / 29

Reserve management under a currency board Results

Results

Quir´

• s and Mendiz´

abal (2006): interest rates should be increasing. Intuition: “Probability of going to the deposit facility should be increasing over time”. This paper: Interest rates can be decreasing or increasing Intuition: Probability of not meeting the reserve requirement is increasing or decreasing depending on the aggregate availability of funds.

Marius Jurgilas (University of Connecticut) Interbank Markets under Currency Boards August 2007 16 / 29

Monetary policy under a currency board Motivation

Fourth essay: Monetary policy under a currency board

Currency board = no activist monetary policy Recent changes in foreign currency exchange transaction costs Is there a connection? This paper: Changes in foreign currency exchange transaction costs may have the same effects as a change in the monetary policy stance

Marius Jurgilas (University of Connecticut) Interbank Markets under Currency Boards August 2007 17 / 29

Monetary policy under a currency board Motivation

Fourth essay: Monetary policy under a currency board

Currency board = no activist monetary policy Recent changes in foreign currency exchange transaction costs Is there a connection? This paper: Changes in foreign currency exchange transaction costs may have the same effects as a change in the monetary policy stance

Marius Jurgilas (University of Connecticut) Interbank Markets under Currency Boards August 2007 17 / 29

Monetary policy under a currency board Motivation

Fourth essay: Monetary policy under a currency board

Currency board = no activist monetary policy Recent changes in foreign currency exchange transaction costs Is there a connection? This paper: Changes in foreign currency exchange transaction costs may have the same effects as a change in the monetary policy stance

Marius Jurgilas (University of Connecticut) Interbank Markets under Currency Boards August 2007 17 / 29

Monetary policy under a currency board Model

Two Period Model

Two period two sector economy:

Two firms (1,2) Two types of households (a,b) Two banks (x,y) Government

i.i.d. productivity shocks

Marius Jurgilas (University of Connecticut) Interbank Markets under Currency Boards August 2007 18 / 29

Monetary policy under a currency board Model

Model Structure

Figure: Structure of the model environment

Marius Jurgilas (University of Connecticut) Interbank Markets under Currency Boards August 2007 19 / 29

Monetary policy under a currency board Model

The Firm’s Problem

Both firms pay marginal product: Production technology: Yi = AziK α

i , A > 0, i = {1, 2}

Return on capital and labor: rli = MPk(zi, Ki) wi = MPl(zi, Ki) Ki = kxi + kyi

Marius Jurgilas (University of Connecticut) Interbank Markets under Currency Boards August 2007 20 / 29

Monetary policy under a currency board Model

The Household’s Problem

max

dha ln(cγ 1,aac1−γ 1,ab ) + β E z ln(cγ 2,aac1−γ 2,ab ))

s.t. c1,aa + c1,abǫ1(DH) + da + ba = Ya c2,aa + c2,abǫ2(DH)(rdx − rfx) = dardx + w1(z1, kx1, ky1) + batr c2,abǫ2(DH) ≤ da z ∈ {(zb

1 , zb 2 ), (zg 1 , zb 2 ), (zb 1 , zg 2 ), (zg 1 , zg 2 )}, with prob. distribution P

dha = {c1,aa, c1,ab, da, ba, c2,aa, c2,ab} DH = {C1,ia, C1,ib, Di, Bi, C2,ia, C2,ib}, i = {a, b} DB = {rdj, Ij1, Ij2, rzj}, j = {x, y}

Marius Jurgilas (University of Connecticut) Interbank Markets under Currency Boards August 2007 21 / 29

Monetary policy under a currency board Model

The Bank’s Problem

Bank x solves the following problem: max

dbx

E [R] − ρ 2Var(R) s.t. R = kx1(rl1 − δ) + kx2(rl2ǫ2 − δ) + (da − c2,abǫ2)rdx −c2,abrfxǫ2 + (rzx − c2,abǫ)r − batr rzx = da − Ix1 − Ix2 kx1 = k0x1 + Ix1 kx2 = k0x2 + Ix2 dbx = {rdx, Ix1, Ix2, rzx}

Marius Jurgilas (University of Connecticut) Interbank Markets under Currency Boards August 2007 22 / 29

Monetary policy under a currency board Results

Simulation Results

(a) Interbank market interest rate: state dependent equilibrium interest rates within the channel system (b) Capital accumulation: individual bank investment levels (firm 1 and firm 2) and aggregate investment

Figure: Currency board with ¯ r = rw = 10.7%

Marius Jurgilas (University of Connecticut) Interbank Markets under Currency Boards August 2007 23 / 29

Monetary policy under a currency board Results

Simulation Results

(a) Interbank market interest rate: state dependent equilibrium interest rates within the channel system (b) Capital accumulation: individual bank investment levels (firm 1 and firm 2) and aggregate investment

Figure: Currency board with ¯ r = 10.7%, rw = 12%

Marius Jurgilas (University of Connecticut) Interbank Markets under Currency Boards August 2007 24 / 29

Monetary policy under a currency board Results

Simulation Results

(a) Interbank market interest rate: state dependent equilibrium interest rates within the channel system (b) Capital accumulation: individual bank investment levels (firm 1 and firm 2) and aggregate investment

Figure: Currency board with ¯ r = 10.7%, rw = 9%

Marius Jurgilas (University of Connecticut) Interbank Markets under Currency Boards August 2007 25 / 29

Monetary policy under a currency board Results

Results

Why change the transaction costs on foreign exchange? Lower variability of interest rates. Changing transaction costs can change the effective interest rate. Opportunity for activist monetary policy under a currency board.

Marius Jurgilas (University of Connecticut) Interbank Markets under Currency Boards August 2007 26 / 29

Monetary policy under a currency board Results

Results

Why change the transaction costs on foreign exchange? Lower variability of interest rates. Changing transaction costs can change the effective interest rate. Opportunity for activist monetary policy under a currency board.

Marius Jurgilas (University of Connecticut) Interbank Markets under Currency Boards August 2007 26 / 29

Monetary policy under a currency board Results

Results

Why change the transaction costs on foreign exchange? Lower variability of interest rates. Changing transaction costs can change the effective interest rate. Opportunity for activist monetary policy under a currency board.

Marius Jurgilas (University of Connecticut) Interbank Markets under Currency Boards August 2007 26 / 29

Monetary policy under a currency board Results

Results

Why change the transaction costs on foreign exchange? Lower variability of interest rates. Changing transaction costs can change the effective interest rate. Opportunity for activist monetary policy under a currency board.

Marius Jurgilas (University of Connecticut) Interbank Markets under Currency Boards August 2007 26 / 29

Conclusion

Concluding Remarks

First essay: Overview of interbank market structure under a currency board Second essay: Empirical investigation of liquidity effect and interest rate dynamics within the reserve holding period Third essay: Theoretical model showing that interest rates can be decreasing Fourth essay: There may be a possibility for activist monetary policy under a currency board

Marius Jurgilas (University of Connecticut) Interbank Markets under Currency Boards August 2007 27 / 29

Conclusion

Concluding Remarks

First essay: Overview of interbank market structure under a currency board Second essay: Empirical investigation of liquidity effect and interest rate dynamics within the reserve holding period Third essay: Theoretical model showing that interest rates can be decreasing Fourth essay: There may be a possibility for activist monetary policy under a currency board

Marius Jurgilas (University of Connecticut) Interbank Markets under Currency Boards August 2007 27 / 29

Conclusion

Concluding Remarks

First essay: Overview of interbank market structure under a currency board Second essay: Empirical investigation of liquidity effect and interest rate dynamics within the reserve holding period Third essay: Theoretical model showing that interest rates can be decreasing Fourth essay: There may be a possibility for activist monetary policy under a currency board

Marius Jurgilas (University of Connecticut) Interbank Markets under Currency Boards August 2007 27 / 29

Conclusion

Concluding Remarks

First essay: Overview of interbank market structure under a currency board Second essay: Empirical investigation of liquidity effect and interest rate dynamics within the reserve holding period Third essay: Theoretical model showing that interest rates can be decreasing Fourth essay: There may be a possibility for activist monetary policy under a currency board

Marius Jurgilas (University of Connecticut) Interbank Markets under Currency Boards August 2007 27 / 29

Conclusion

Thank you!

Marius Jurgilas (University of Connecticut) Interbank Markets under Currency Boards August 2007 28 / 29

References

List of References

Carpenter, S., & Demiralp, S. (2006, June). The Liquidity Effect in the Federal Funds Market: Evidence from Daily Open Market

• Operations. Journal of Money, Credit, and Banking, 38(4), 901-920.

Gaspar, V., Quiroz, P., & Mendizabal, H. (2004, April). Interest rate determination in the interbank market. European Central Bank Working Paper(351). Hamilton, J. D. (1996, June). Measuring the liquidity effect (University of California at San Diego, Economics Working PaperSeries). Department of Economics, UC San Diego. Quir´

• s, G. P., & Mendiz´

abal, H. R. (2006). The daily market for funds in europe: What has changed with the EMU? Journal of Money, Credit and Banking, 38, 91-117. Thornton, D. L. (2001, July/August). Identifying the liquidity effect at the daily frequency. Federal Reserve Bank of St. Louis Review, 59-78. Thornton, D. L. (2006). The daily liquidity effect (Working Papers No. 2006-020). Federal Reserve Bank of St. Louis. ]lit

Marius Jurgilas (University of Connecticut) Interbank Markets under Currency Boards August 2007 29 / 29