Liquidity, Liquidity Everywhere, Not a Drop to Use: Why Flooding Banks with Central Bank Reserves May Not Expand Liquidity

63 Pages Posted: 26 Jan 2022 Last revised: 6 Sep 2022

See all articles by Viral V. Acharya

Viral V. Acharya

Professor; New York University - Leonard N. Stern School of Business; New York University (NYU) - Department of Finance; Centre for Economic Policy Research (CEPR); European Corporate Governance Institute (ECGI); National Bureau of Economic Research (NBER)

Raghuram G. Rajan

University of Chicago - Booth School of Business; International Monetary Fund (IMF); National Bureau of Economic Research (NBER)

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Date Written: January 25, 2022

Abstract

Central bank balance sheet expansion is financed by commercial banks. It involves not just a substitution of liquid central bank reserves for other assets held by commercial banks, but also a counterpart increase in commercial bank liabilities, such as short-term deposits issued to finance reserves. Banks typically also write a variety of other claims on reserve holdings. These claims reduce the net future availability of liquidity to the system, dampening the normal effect of reserves in improving liquidity. In episodes of stress when a large fraction of claims on liquidity are exercised, the demand for liquidity can even exceed available reserves, made scarcer due to hoarding by some liquid commercial banks. Therefore, because central bank balance sheet expansion operates through commercial bank balance sheets, it need not eliminate future episodes of liquidity stress, it may even exacerbate them. This may attenuate any positive monetary effects of reserve expansion on economic activity.

JEL Classification: E0,G0

Suggested Citation

Acharya, Viral V. and Acharya, Viral V. and Rajan, Raghuram G., Liquidity, Liquidity Everywhere, Not a Drop to Use: Why Flooding Banks with Central Bank Reserves May Not Expand Liquidity (January 25, 2022). University of Chicago, Becker Friedman Institute for Economics Working Paper No. 2022-19, Available at SSRN: https://ssrn.com/abstract=4017741 or http://dx.doi.org/10.2139/ssrn.4017741

Viral V. Acharya

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New York University - Leonard N. Stern School of Business ( email )

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HOME PAGE: http://www.stern.nyu.edu/~vacharya

New York University (NYU) - Department of Finance

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