This paper examines the impact of voluntary and involuntary excess liquidity on monetary policy effectiveness and inflation in Kazakhstan. Consistent with first-principles predictions, we find that voluntary liquidity held for precautionary motives is (i) negatively related to the opportunity cost of holding liquid assets and to the level of mandatory reserve requirements; (ii) positively related to average liquidity outflows, proxied by transactional demand for cash; and (iii) ambiguously affected by the magnitude and volatility of the business cycle. We further show that higher voluntary liquidity weakens monetary policy transmission and increases exchange rate pass-through to inflation. In contrast, involuntary liquidity hampers monetary policy effectiveness no matter its level and it increases average inflation primarily through its influence on the formation of inflation expectations. Overall, the results suggest that reforms aimed at reducing both forms of liquidity would enhance monetary policy effectiveness and, ceteris paribus, reduce inflation.
Impavido et al. (Mon,) studied this question.