The Role of Excess Liquid Assets in Monetary Policy of Small Open Developing Economies

Abstract

The central bank in an open developing economy often balances the national foreign exchange market by selling liquid assets (typically domestic sovereign securities) to commercial banks and other institutional investors that would otherwise be motivated to invest in foreign financial assets. Therefore, securities denominated in domestic currency, ostensibly sold in the name of “mopping up excess reserves”, serve as a compensation transmission mechanism under which international reserves and the exchange rate target are central. This transmission mechanism allows the central bank to target the exchange rate while also pursuing an independent monetary policy under free capital mobility, thus to a large degree circumventing the Trilemma. In addition, the securities serve the other purpose of reducing the volatility of the portfolio of bank assets. In an imperfectly competitive security market, this compensation strategy is less expensive than would result if the strategy is to be implemented in a purely competitive securities market.