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

Central bank balance sheet expansion is run through commercial banks. While liquid central bank reserves held on commercial bank balance sheets increase, demandable uninsured deposits issued to finance the reserves also increase. A subsequent shrinkage in the central bank balance sheet may entail a shrinkage in bank-held reserves without a commensurate reduction in deposit claims. Furthermore, during episodes of liquidity stress, when many claims on liquidity are called, surplus banks may hoard reserves. As a result of such bank behavior, central bank balance sheet expansion may create less systemic liquidity than typically thought, and in fact, the demand for liquidity can occasionally exceed available reserves, exacerbating liquidity stress.