Research / BFI Working PaperNov 21, 2022

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

Viral V Acharya, Raghuram Rajan

Central bank balance sheet expansion is financed by commercial banks. Apart from substituting liquid central bank reserves for other assets held by commercial banks, which enhances the availability of liquidity, it entails an increase in commercial bank liabilities, such as demandable deposits, issued to finance reserves. Banks typically also write other claims on reserve holdings. During future episodes of stress when many claims on liquidity are exercised and surplus banks hoard reserves, the demand for liquidity can exceed available reserves, exacerbating liquidity stress. This may attenuate any positive monetary effects of reserve expansion on economic activity.

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