DP788 Liquidity Effects and the Determinants of Short-term Interest Rates in Italy (1991-92)

Author(s): Ignazio Angeloni , Alessandro Prati

Publication Date: May 1993

Keyword(s): EMS , Liquidity Effects , Reserve Requirements

JEL(s): E43 , E52 , F41

Programme Areas: International Macroeconomics

Link to this Page: www.cepr.org/pubs/dps/DP788.asp

The paper uses Italian daily data from January 1991 to July 1992 (a period in which the lira belonged to the narrow EMS band without foreign exchange controls) to measure the relationship between liquidity and interest rates. The high quality of the data allows us to separate that part of interest rate variability due to foreign exchange factors (i.e. interest rate linkages in the EMS) from that attributable to other (`domestic') factors. We compare and evaluate alternative indicators of daily liquidity in a system of monthly average computation of reserve requirements. We find clear evidence of the existence of liquidity effects on interest rates and, in contrast to the pre-1990 period, find that foreign exchange factors have had a dominant influence, directly or through their effect on domestic liquidity, on interest rate variability.