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On 1 January 1999 a new currency, the euro, was launched and a new institution, the Eurosystem, took over responsibility for the single monetary policy in the euro area, which is one of the largest developed economic areas in the world. However, the euro area is not only large but it is also a heterogeneous economic area since it comprises individual countries with different economic and financial structures. With regards to the size and the heterogeneity of the euro area, the creation of a single currency and a single monetary policy has faced extraordinary challenges, among them the design of suitable instruments and procedures, i.e. of a suitable operational framework, for the conduct of monetary policy.

To achieve its primary goal of maintaining price stability in the euro area, the Eurosystem aims at steering short-term money market rates. The EONIA, the reference rate in the interbank market for overnight loans, is the Eurosystem’s operating target. For steering the short-term interest rates, the Eurosystem has at its disposal a set of monetary policy instruments. These instruments are part of the Eurosystem’s operational framework which comprises all of the instruments and procedures used to implement the single monetary policy in the euro area (European Central Bank, 2004c, p. 71). While designing this operational framework, a set of principles has had to be considered. We will briefly present these principles in the next section.

The Eurosystem aims at steering the interbank money market rates in the euro area, the EONIA is its operational target. Figure 3.1 shows that the EONIA has tracked closely the MRO-rate, i.e. the ECB policy rate, so that from this point of view the Eurosystem’s operational framework has performed well.

The aim of this chapter is twofold. First, we will introduce in a rather simple framework the basic structure of the theoretical models presented in this work. Second, we will present a key result of this work by providing the rationale behind the existence of the interbank money market.

In this chapter, we expand the base model by assuming that there are two time periods which cover a reserve maintenance period. For fulfilling their reserve requirements banks can make use of averaging provisions. An important feature of our model is that reserves are remunerated at the end of each period at the current repo rate. As in the base model, the banks can cover their liquidity needs either by borrowing from the central bank or in the interbank market where they can also place liquidity. A further crucial feature of our model is that the banks can borrow in each period from the central bank as well as in the interbank market, and that the maturities of all loans is one period, i.e. the maturities of the central bank credits do not overlap. Within this framework, the banks have to decide on their optimal borrowing from the central bank, their optimal transactions in the interbank market, and on the optimal intertemporal allocation of their required reserve holdings. A main result is that within this model framework, the banks’ liquidity management is not influenced by a change in the repo rate within the reserve maintenance period. Independently of a change in the repo rate, reserves are provided smoothly over the maintenance period and borrowing from the central bank corresponds to the central bank’s benchmark. Moreover, we show that banks are not affected differently by a monetary impulse in the form of a change in the repo rate.

In this chapter, we change the current rate model presented in the previous chapter by assuming that reserves are remunerated at the average of the repo rates and at the end of the second period instead of at the current repo rate at the end of each period. We will show that under this different assumption concerning the remuneration of required reserves, interest rate changes do influence the banks’ optimal liquidity management. If the central bank cuts (raises) the repo rate, banks will postpone (frontload) holdings of required reserves which implies that also on aggregate reserves will be provided unevenly. This again implies that aggregate central bank borrowing will deviate from the benchmark, i.e. underbidding (overbidding) will occur. Furthermore, we will show that banks are not only affected differently by a monetary policy impulse in form of a change in reserve requirements but also by a monetary policy impulse in form of a change in the repo rate. Moreover, it will turn out that the interbank market rate is smoothed in the sense that it will slightly decrease (increase) even before the central bank actually cuts (raises) the repo rate.

In this chapter, we change the average rate model presented in the previous chapter by assuming that there are overlapping maturities of central bank credits. We will show that the overlapping maturities imply that central bank borrowing will deviate even more from the central bank’s benchmark amount and that even more required reserves will be postponed if the repo rate is cut. If the repo rate is raised, the overlapping maturities imply that central bank borrowing deviates even more from the central bank’s benchmark amount and that even more required reserves are frontloaded. Furthermore, we will show that banks are affected differently by a monetary policy impulse if the repo rate is cut and that they be affected differently if the repo rate is raised. Moreover, we will demonstrate that the overlapping maturities may prevent a smoothing of the interbank market rate.

This chapter presents the implications of the theoretical analysis for the Eurosystem’s operational framework. We start with a comment on the implications for the interbank market rate in the euro area. Then, we focus on the question which of the three models presented (current rate model, average rate model, overlapping maturities model) most closely fulfills the requirements that should be met by Eurosystem’s operational framework. We go on to evaluate the 2004-changes to the Eurosystem’s monetary policy instruments. Finally, we suggest a further measure to improve the Eurosystem’s operational framework.

In January 1999, the euro was launched and the Eurosystem took over the responsibility for the single monetary policy in the euro area. This creation of a new currency and a single monetary policy in a large and relatively heterogeneous economic area has been related to extraordinary challenges. Among these challenges there has been the development of an appropriate operational framework, i.e. of appropriate instruments and procedures for the conduct of monetary policy.