Central Bank Liquidity Management and “Unconventional” Monetary Policies
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Central Bank Liquidity Management and “Unconventional” Monetary Policies

Central banks that work under an inflation-targeting regime generally use an interest rate as the main instrument to implement monetary policy. The latter can be denominated conventional monetary policy. Central banks often deviate from this practice, however, and engage in other policies to deal with particular situations. As these alternatives depart from the usual practice, they are generally labeled “unconventional” policies.

During the recent global financial crisis and recession of 2008–09, central banks around the world and in Latin America, in particular, responded to external shocks in a variety of ways. Canales-Kriljenko and others provide a precise description of how different Latin American central banks reacted to the U.S. financial crisis shock in 2008, with an emphasis on the heterogeneity in the use of unconventional monetary policy instruments.1 For example, while Colombia and Peru lowered reserve requirements in their banking systems, the Central Bank of Chile relaxed the collateral requirements for repurchase (repo) transactions.2 Also, Chile and Peru extended the repayment period in repo transactions. These examples illustrate not only the heterogeneity in responses, but also the prevalent use of unconventional instruments. Ishi, Stone, and Yehoue note that [End Page 39] the central bank interest rate increased rather than decreased in many emerging countries in the months immediately following the fall of Lehman Brothers.3

Deviations from conventional policies were observed in Latin America even before the recent global financial crisis (and before the central banks implemented inflation-targeting frameworks). Most notably, central banks have often engaged in sterilized exchange rate interventions to smooth the effects of capital inflows (due in part to commodity price booms) and the resulting nominal exchange rate appreciation. Some countries, like Peru, have used these interventions quite frequently, whereas others have implemented these policies only after extreme movements in the nominal exchange rate (for instance, in Chile), even after the inflation-targeting policies were already in place.

In this regard, one important policy discussion is the relationship between inflation-targeting regimes and liquidity management responses.4 In particular, it is not obvious whether the application of such liquidity management policies implied some type of threat to the “good implementation” of the inflation-targeting framework. Ishi, Stone, and Yehoue highlight the difficulties of using econometric time-series techniques to evaluate the impact of liquidity management policies implemented in an inflation-targeting framework, because it requires disentangling the impact of each type of policy, as well as the impact of the external shocks that presumably triggered the implementation of such policies.5 The fact that such policies were usually in place for just a few quarters further complicates the application of the time-series-based impact evaluation.

This paper contributes to the evaluation of such policies by constructing, solving, and simulating a dynamic stochastic general equilibrium (DSGE) model that explicitly includes the central bank’s balance sheet as a key modeling input. The model can explicitly predict the impact of selected unconventional monetary policies on the major macroeconomic variables, including gross [End Page 40] domestic product (GDP), consumer price index (CPI) inflation, and the real exchange rate, and it pays special attention to the role played by the specific facilities used by the central bank to manage market liquidity. This paper uses Chile as the main case for the application of the model, providing a detailed account of its experience with these alternative tools since the introduction of the flexible inflation-targeting framework in 1999 and calibrating the model to then analyze the effects of some of the policies implemented.

The theoretical framework is an extension of a New Keynesian model of a small open economy with banks that take deposits from households (which is the only way for the latter to finance consumption, extending the more traditional cash-in-advance assumption), borrow abroad, lend to productive firms, and hold bonds issued by the central bank. A key ingredient of the model is that it explicitly includes the facilities that the central bank sets up to allow banks to obtain liquidity. In these facilities, banks can acquire liquidity in exchange for a specific list...