Central Banks in Uncharted Waters: Navigating a World with Large Reserves

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AbstractDuring the last decade many central banks, including the US Federal Reserves and the European Central Bank (ECB), have grown tremendously to become much more important players in financial markets. Furthermore, advances in information technology have led to proposals of an even larger footprint through Central Bank Digital Currencies as well as looming competition from private monies. As a byproduct of these developments, central banks have dramatically increased their short-term liabilities and are considering further increases to sustain a massive increase in liquidity provision. This project explores the role of the recent transformation of central banks for the conduct of monetary policy, and the implications of digital currencies on the efficiency of the payment system.This project develops a new framework to analyze monetary policy. The existing framework on monetary policy views the Federal Reserve as directly setting the nominal short-term interest rate at which households save and firms finance their investments. This view does not explain recent empirical evidence in the bond pricing literature which has documented a convenience yield on short bonds. This convenience yield is not only quantitatively large on average, it also varies over the business cycle. The model does not explicitly describe the behavior of banks, which are thought of as a veil. The framework developed in this project considers the role of financial intermediaries on monetary policy and takes into consideration the quantity of reserves in addition to a Taylor-type interest-rate rule. Finally, the project considers implications of central bank digital currency on monetary policy and the payment system.This award reflects NSF's statutory mission and has been deemed worthy of support through evaluation using the Foundation's intellectual merit and broader impacts review criteria.