The Dynamics of Involuntary Commercial Banks’ Reserves in Trinidad and Tobago

Abstract

This paper examines the dynamics of excess liquidity in a small open energy producing economy, namely Trinidad and Tobago. The banking system in that country has persistently recorded high excess liquidity. For example, during 2010, excess reserves increased by six times what it was three years earlier. This has posed serious challenges for the Central Bank given the market based style of monetary policy adopted. We argue that an accumulation of excess reserves beyond prudential levels can be offsetting to monetary policy. To estimate the dynamics of involuntary excess reserves we use a two-step procedure. The first step employs Generalized Method of Moments (GMM) to examine how liquidity needs impact on the holding of precautionary excess reserves. The GMM model reveals that commercial banks hold excess reserves for precautionary purposes. Second, we employ impulse response functions to explore the dynamic effects of increased government expenditure on involuntary reserves held by commercial banks. The generalized impulse responses, obtained from a Vector Error Correction (VEC) model, show that government expenditure leads to sustained elevation of involuntary reserves.