Recent empirical studies of the `liquidity effects' of monetary expansions which reduce interest rates in contrast to the predictions of the real business cycle model have typically focused on closed economies or those with floating rates and have thus ignored the role of the exchange rate. In small open economies operating target zones, divergence of domestic from international interest rates depends on the size of the band, the extent of capital mobility and the risk of parity changes. In Discussion Paper No. 788, Ignazio Angeloni and Research Affiliate Alessandro Prati consider the recent Italian experience using daily data from January 1991 to July 1992 to examine the interaction between bank liquidity, foreign exchange shocks and money-market interest rates.

In 1990, a new computation system was introduced which allowed banks to fulfil reserve obligations on a monthly average rather than a daily basis. This greatly increased the depth and efficiency of the money market, reduced the volatility of interest rates and strengthened their short-run relationship with bank liquidity. The lira also joined the narrow band of the EMS, and all residual controls on foreign capital flows were removed.

Angeloni and Prati employ a model in which domestic and foreign monetary shocks determine domestic short-term interest rates to separate variability due to EMS linkages from that due to domestic factors. Their results indicate that interest rate movements were almost entirely driven by foreign exchange factors, either directly or through the liquidity effects of central bank intervention, which contrasts sharply with the patterns before 1990. This suggests that Italian monetary policy concentrated on maintaining the stable exchange rate within the ERM narrow band; the narrowing of this band and the removal of exchange controls drastically reduced the scope for independent monetary policy, as predicted by the `asymmetric view' of the EMS.

Liquidity Effects and the Determinants of Short-term Interest Rates in Italy (1991-92)
Ignazio Angeloni and Alessandro Prati

Discussion Paper No. 788, May 1993 (IM)