No. 199 - Liquidity Effects and the Determinants of Short-Term Interest Rates in Italy

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 relation between bank liquidity and money market interest rates. Alternative indicators of daily liquidity in a system of monthly average computation of reserve requirements are compared and evaluated. Differently from the rest of the literature, we identify liquidity effects by constructing rather than assuming a perfectly inelastic daily supply function with respect to the interbank rate. In addition, we separate the 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. Contrary to the pre-1990 period, we find that foreign exchange factors have had a dominant influence on interest rate variability.