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Optimal allotment policy in central bank open market operations

Christian Ewerhart (), Nuno Cassola, Steen Ejerskov and Natacha Valla

The European Journal of Finance, 2009, vol. 15, issue 4, 405-420

Abstract: This article derives a central bank's optimal liquidity supply towards a money market with an unrestricted lending facility. We show that when the effect of liquidity on market rates is not too small, and the monetary authority is concerned with both interest rates and liquidity conditions, then the optimal allotment policy may entail a 'discontinuous' reaction to initial conditions. In particular, the model predicts a threshold level of liquidity below which the central bank will not bail out the banking system. An estimation of the liquidity effect for the euro area suggests that the discontinuity might have contributed to the Eurosystem's tight response to occurrences of underbidding during the period June 2000 through March 2004.

Keywords: open market operations; liquidity effect; standing facilities; underbidding (search for similar items in EconPapers)
Date: 2009
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Handle: RePEc:taf:eurjfi:v:15:y:2009:i:4:p:405-420