Nuno Cassola

A Money Demand System for Euro Area M3

In order to assess the importance of monetary and financial developments for key macroeconomic variables in the euro area a money demand system for M3 is estimated adopting a structural cointegrating VAR approach. While maintaining a good statistical representation of the data, long-run relationships are based on economic theory. By using generalized response profiles the dynamics of the money demand system is investigated without any further identifying assumptions. Error bounds of the profiles are derived using bootstrap simulations.

Declining Valuations and Equilibrium Bidding in Central Bank Refinancing Operations

Among the most puzzling observations for the euro money market are the bid shading in the weekly refinancing operations and the development of interest rate spreads. To explain these observations, we consider a standard divisible-good auction a la Klemperer and Meyer (1989) with uniform or discriminatory pricing, and place it in the context of a secondary market for interbank credit. The analysis links the observations for the euro area to the endogenous choice of collateral in credit transactions. We also discuss the Eurosystem’s apparent preference for the discriminatory pricing rule.

A two-factor model of the German term structure of interest rates

This paper shows that a two-factor constant volatility model provides an adequate description of the dynamics and shape of the German term structure of interest rates from 1972 up to 1998. The model also provides reasonable estimates of the volatility and term premium curves. Following the conjecture that the two factors driving the German term structure of interest rates represent the ex-ante real interest rate and the expected inflation rate, the identification of one factor with expected inflation is discussed. The estimates are obtained using a Kalman filter and a maximum likelihood procedure including in the measurement equation both the yields and their volatilities.

Volatility of interest rates in the euro area: Evidence from high frequency data

The paper studies the euro area money market from a microstructure perspective. The focus is on the empirical estimation of the factors underlying the volatility of the overnight interest rate and its transmission along the money market yield curve. Two sources of volatility are separated out, one related to the institutional features of the operational framework and payments system, and the other, related to the impact of policy decisions. A novel data set is used composed of hourly observations and covering several short-term interest rates. The sample runs from 4/12/2000 to 31/05/2002. Two common long-memory factors are found to drive the volatility processes. The first explains the long-memory dynamics of the shortest maturity. The other explains the transmission of volatility to other maturities. It is shown that announcements of interest rate changes exercise the strongest impact on the volatility of the shortest maturities. Persistent effects of liquidity shortages that are transmitted along the money market yield curve are documented. However, these effects are not the rule and can be explained by exceptional circumstances.

Manipulation in Money Markets

Interest rate derivatives are among the most actively traded financial instruments in the main currency areas. With values of positions reacting immediately to the underlying index of daily interbank rates, manipulation has become an increasing challenge for the operational implementation of monetary policy. To address this issue, we study a microstructure model in which a commercial bank may have strategic recourse to central bank standing facilities. We characterise an equilibrium in which market rates will be manipulated with strictly positive probability. Our findings have an immediate bearing on recent developments in the Sterling and Euro money markets.

Optimal allotment policy in central bank open market operations

This article derives a central banks 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 Eurosystems tight response to occurrences of underbidding during the period June 2000 through March 2004.

Understanding Chinese Bond Yields and Their Role in Monetary Policy

Chinas financial prices are informative enough for the PBC to introduce a monetary policy framework centered around interest rates. While bond yields are not fully efficient?reflecting regulation, liquidity, and segmentation?we find they contain considerable information about the state of the economy as well as evidence of an emerging transmission channel: changes in PBC rates influence the structure of Treasury, financial, and corporate bond yield curves, which are then associated with changes in growth and inflation. Coporate spreads are also a leading indicator of growth and inflation. While further liberalization will strengthen both efficiency and transmission, several necessary elements to move towards indirect monetary policy are already in place.