The Liquidity Effect in the Euro Area

This paper presents an analysis of the liquidity effect in the euro area – the link between the availability of aggregate liquidity and the interbank overnight rate. Applying a set of assumptions which also lead to the “martingale property” of the overnight rate, a model linking the latter to the expected aggregate liquidity conditions is formulated and calibrated. Different assumptions for how the market is establishing its expectation and uncertainty about the aggregate liquidity conditions are tested for. It is found that the dynamics of the overnight rate is consistent with market participants having, in aggregate, a rather precise expectation about the aggregate liquidity conditions, however, with an apparent uncertainty which by far exceeds the rather limited variance of the error of this expectation. While the model presented here provides a rather good fit of the overnight rate this indicates that further aspects than just the dynamics of the aggregate liquidity conditions need to be included in order to conceptually describe the overnight rate. An EUR 1 billion expected liquidity imbalance on the last day of the maintenance period is estimated to, ceteris paribus, affect the overnight rate by 7 basis points on that day. JEL Classification numbers: C32, E43, E52