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Open Market Operations and the Price of Liquidity: The Case of the Czech Republic between 1998 and 2004

Effective monetary policy depends on the ability of central banks to stabilize fluctuations of overnight interest rates around their policy rate. The function of the stabilization mechanism involves balancing aggregate bank demand for reserves with the central bankâ€™s supply of reserves in the interbank market. This paper discusses the main sources of temporal gaps between the demand for and the supply of reserves and their impact on overnight interest rate volatility. A theoretical explanation of the role of intertemporal substitution in periods of fluctuating reserves demand is provided. Crucial features of central bank targeting of overnight interest rates are discussed. The behavior of overnight interest rates in the Czech interbank market (1998-2004) is empirically examined in the context of excess liquidity. Some relevant structural changes in the interbank market are identified. Specifically, we find undershooting of the non-stability of excess liquidity in the interbank market and a sharp decline of overnight interest rate volatility associated with the introduction of intraday credit.