II. Liquidity Management Framework for Structural Deficit

Monetary Theory
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45
which is not equivalent to the ex ante level of reserves demand, or does not 
adjust reserves supply, then as a result, reserves demand will change over the 
long run and the equilibrium level of demand and supply of the reserves will 
eventually be realized. The equation is as follows:
(Ex ante) Reserves Demand ≠ (Ex post) Reserves Supply 
= (Ex post) Reserves Demand
Ex ante reserves demand is not equal to ex post reserves demand (or ex post 
reserves supply), and in the short term the difference is reflected in “buffer 
stock reserves” not anticipated by commercial banks
16
(Sun, 1996). Buffer 
stock reserves will exist in the short term, mainly because the cost brought 
about by a short-term increase or decrease in reserves is lower than the 
adjustment cost of commercial banks. Before understanding whether this 
kind of impact will last for a long time or a short time, commercial banks 
will accept this change in the short term. Thereafter, if commercial banks 
deem this change to be long-term in nature, it will affect the parameters or 
independent variables of their reserves demand functions. The former means 
that commercial banks will tolerate the change of unanticipated reserves, 
and the latter indicates commercial banks will take measures to change the 
scale and structure of their assets and liabilities. In summary, after the shock 
of monetary policy operations, the actual quantity of reserves will equal to 
the long-term level of reserves demand. At that time, buffer stock reserves 
will be absorbed by reserves demand.
17
Active monetary policy operations 
undertaken by the central bank are designed to exert an exogenous influence 
on the supply and demand of reserves to produce unanticipated buffer stock 
reserves in the hope that commercial banks will change the scale and struc-
ture of their assets and liabilities to adjust reserves demand and use up buffer 
stock reserves (rather than tolerating a change in unanticipated reserves), 
thereby changing their deposit liabilities in the direction they themselves 
anticipate. 
Regardless of whether the central bank undertakes defensive operations 
or active operations to change the reserve demand/supply relationship, the 
central bank certainly hopes to put itself in an advantaged position. In this 
regard, a reasonable liquidity management framework needs to be designed. 
The primary goal in designing a liquidity management framework is to deal 
with the relations between ex ante reserves demand and ex ante reserves sup-
ply. If ex ante reserves demand is greater than ex ante reserves supply, then the 
central bank will be in the position of lender (funding provider). Otherwise, 
the central bank will be in the position of borrower (funding demander). For 
different practices adopted by different central banks, central banks prefer to 

46
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Reforms in China’s Monetary Policy
act as lenders than borrowers. This is partly because lenders are always in an 
advantaged negotiating position among parties in financing arrangements, 
and partly because lenders obtain interest income and borrowers have to pay 
the cost of interest. Hence, the liquidity management framework must be 
designed to be a pattern whereby ex ante reserves demand is greater than ex 
ante reserves supply, that is, a structural liquidity deficit exists, putting the 
central banks in an advantaged position as lenders. 
Moreover, after establishing the basic liquidity deficit pattern, a unidirec-
tional rigidity of the reserves demand function must be designed to guarantee 
the validity of monetary policy operations. As mentioned above, the channel 
by which monetary policy operations play their role is to change the demand-
to-supply ratio of reserves with the specific target of producing “buffer stock 
reserves.” If the elasticity of reserves demand is too strong, commercial banks 
will instantaneously use up the unanticipated change in reserves and no buf-
fer stock reserves will emerge; alternatively, after buffer stock reserves gen-
erate, most commercial banks will tolerate to use up buffer stock reserves 
over the long run, which will not bring about changes in commercial banks’ 
deposit liabilities that the central bank wishes to see. In that case, the reserves 
demand function must have a considerable degree of rigidity to guarantee 
that the reserve demand-to-supply ratio changes after the central bank adjusts 
reserves demand, thereby producing buffer stock reserves and allowing such 
reserves to play their role. Subject to the precondition of liquidity deficit, 
reserves demand rigidity should be designed in a unidirectional manner, that 
is, downward rigidity of reserves demand. Under conditions of liquidity defi-
cit and downward rigidity of reserves demand, if the central bank does not 
increase reserves supply, commercial banks cannot reduce reserves demand 
themselves to realize equilibrium between the demand for and supply of 
reserves. In addition, the central bank monetary policy operations aimed at 
increasing the supply of reserves will certainly obtain the cooperation of com-
mercial banks and will subsequently be realized. The interest rate level for 
such transactions will become the “marginal interest rate” in the market with 
a decisive effect on the market interest rate level. This effect is not completely 
symmetrical with the central bank trading volume. The Figure 1.3 shows the 
specific constituents and determinants of demand and supply of the reserves 
in actual central banks operations.
Figure 1.3 reflects the liquidity management framework of the central 
banks of many developed countries, and the actual operations of these central 
banks are in consistent with the logical analysis set out in this chapter: the 
required reserves system is designed to create mandatory reserves demand 
among commercial banks, and the central bank provides liquidity mainly 
via open market operations. To develop, commercial banks need to expand 

Commercial
Bank
Deposits
Required
Deposit
Reser
v
e
Ratio
Required
reser
v
es
Non-
Borro
wing
Reser
v
es
Stoc
k Cash
T
ransf
er of Cash Held b
y the Pub
lic
Open Mar
k
et Oper
ations
Re-discount of Centr
al Bank
T
otal Reser
v
es
T
otal Reser
v
es Supply
T
otal Reser
v
es Demand
Changes in Other Items on the
Balance Sheet of Assets and
Liabilities of the Centr
al Bank
Deposits
at the
Centr
al
Bank
Borro
wing
Reser
v
es
Excess
Reser
v
es
P
a
y
ab
le Withdr
a
w
als
,
Clear
ing Demand and
Uncer
tainty

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