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A Simple Interest Rate Model with Unobserved Components

: The Role of the Interbank Reference Rate

December 10, 2012
Ichiro Muto*1

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Abstract

In this study, we theoretically investigate the potential role of the reference rate in stabilizing or destabilizing an interbank market with an environment where individual banks cannot fully identify the nature of underlying shocks affecting their interbank transactions. We show that a noise-free reference rate based on a sufficient number of sample transactions can help to make the market interest rate less volatile, whereas the stabilizing effects of the reference rate are significantly reduced if the reported interest rates contain some noisy components. Nevertheless, by increasing the number of sample transactions reflected in the reference rate, the adverse effects of the noise can be mitigated (or eliminated) provided the noise is idiosyncratic to individual transactions. However, if the noise is common to multiple transactions, then the adverse effects of the noisy reference rate cannot be reduced simply by increasing the number of sample transactions. This suggests that the noise in the interest rates reported by just a few of large banks can end up making the entire market more volatile, thereby impairing the transmission mechanism of monetary policy.

JEL Classifications
E43, E44, G14

Keywords
Interbank Market; Reference Rate; LIBOR; Imperfect Information; Financial Stability; Transmission Mechanism of Monetary Policy.

The author is grateful to Koichiro Kamada, Kosuke Aoki, Teruyoshi Kobayashi, Takeshi Kimura, Hibiki Ichiue, Kenji Nishizaki, Takashi Nagahata, Nao Sudo, and Takemasa Oda for their helpful advice and comments. The views expressed in this paper are those of the author and do not necessarily reflect the official views of the Bank of Japan.

  •   *1 Director, Research and Statistics Department
    E-mail : ichirou.mutou@boj.or.jp

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