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Due to buoyant capital inflows East Asian central banks with exchange rate targets accumulate foreign reserves and thereby increase surplus liquidity. East Asian central banks with more flexible exchange rate regimes also face surplus liquidity that mainly emanates from past accumulation of foreign reserves. We show based on an augmented Barro-Gordon-type central bank loss function that in both cases surplus liquidity limits monetary policy autonomy. In case of fixed exchange rates East Asian central banks can escape from the impossible trinity and gain monetary policy autonomy by using non-market-based sterilization which leads to financial sector distortions. In a flexible exchange rate regime monetary policy autonomy can be gained without financial sector distortions by using market-based sterilization. As central banks face substantial sterilization costs as well as revaluation losses on foreign reserves, however, monetary policy autonomy is eroded.

Given buoyant capital inflows and managed exchange rates the majority of emerging market central banks have continued to accumulate massive foreign reserves. If left unsterilized, the liquidity expansion can threaten domestic macroeconomic stability. To contain domestic inflation these central banks absorb rather then provide liquidity in their regular monetary policy operations. Based on an augmented Barro-Gordon framework we show that inflation targeting within an environment of surplus liquidity is less efficient, because absorbing liquidity raises the costs of monetary policy operations. By implementing sterilization costs into the central bank's objective function the inflation bias increases.

This paper extends the benchmark Macro-Finance model by introducing, next to the standard macroeconomic factors, additional liquidity-related and return forecasting factors. Liquidity factors are obtained from a decomposition of the TED spread while the return-forecasting (risk premium) factor is extracted by imposing a single factor structure on the one-period expected excess holding returns. The model is estimated on US data using MCMC techniques. Two findings stand out. First, the model outperforms significantly most structural and non-structural Macro-Finance yield curve models in terms of cross-sectional fit of the yield curve. Second, we find that financial shocks, either in the form of liquidity or risk premium shocks, have a statistically and economically significant impact on the yield curve. The impact of financial shocks extends throughout the yield curve but is most pronounced at the high and intermediate frequencies.

This paper constructs new indicators of liquidity for equity, bond and money markets in major advanced and emerging market countries, documents their evolution and co-movements, and assesses the extent to which such measures are determinants of selected spreads and proxy measures of countries' growth opportunities. Three main results obtain. First, there is evidence of an historical increase in market liquidity since the early 1990s, in part as a result of advances in international financial integration, but markets have been increasingly exposed to global systemic liquidity shocks. Second, liquidity indicators appear to be important determinants of bond spreads in advanced economies and EMBI spreads in emerging markets. Third, improvements in market liquidity have significant real effects, as liquidity indicators have a significant positive impact on proxy measures of countries' growth opportunities.

Credit booms have globally fuelled hikes in stock, raw material and real estate markets which have culminated in the recent US subprime market crisis. We explain the global asset market booms since the mid 1980s based on the overinvestment theories of Hayek, Wicksell and Schumpeter. We argue that ample liquidity supply originating in the large industrialized countries has contributed to overinvestment cycles in Japan, East Asia, the new markets in the industrial countries and many emerging market economies. Expansionary monetary policies in response to the burst of bubbles are argued to have contributed to vagabonding bubbles around the globe.