THE RELATIONSHIP BETWEEN OUTPUT GAP AND EXCESS LIQUIDITY IN EUROPEAN TRANSITION ECONOMIES

The aim of this thesis is to investigate the definition and measurement of the potential output and the output gap, to examine the definition and determinants of the size and the behaviour of excess liquidity in the banking sector in transition economies and last, to explore the theoretical and empirical links between the output gap and excess liquidity. Estimating potential output and the corresponding output gap is deemed as particularly relevant for the conduct of monetary and fiscal policy as well as in providing useful insights regarding the state of the economy, especially for periods with below potential production. One of the most important factors associated with a large output gap may be the efficiency of financial systems in transition economies, in particular the behaviour of banks, as they represent the main source of finance with capital markets being in their infancy. Access to banking loans is one of the main sources of finance for a firm’s growth, while excess liquidity holdings are a feature of several European transition economies. Thus, another research question addressed in this thesis is why do banks in transition economies continuously accumulate excess reserves in the face of seemingly profitable loans to invest in, relative to developed countries, which are also costly to maintain. Criticizing the prior definitions of excess liquidity in the existing literature as imprecise, another theoretical added value of this thesis consists on clarifying the excess liquidity concept and subsequently redefining its measurement. Augmenting the model with risk, regulatory and institutional variables, the findings suggest that involuntary factors that are mainly outside of banks’ control (e.g. lack of credit demand, poor institutional framework) prevail in inducing banks to accumulate excess reserves, relative to the precautionary motive. Treating potential endogeneity issue between excess liquidity and the output gap, the last finding of this research proclaims that rather being in a causal relationship, both are actually correlated via the common observed and unobserved determinants. Due to the lack of a clear transmission mechanism from one to the other factor, rather than pushing banks to reduce excess liquidity to extend lending and consequently to reduce the output gap, a policy implication of the thesis is that other factors outside of the system that are capable of pushing both variables in the desired direction need to be identified. The avoidance of a policy where banks are pushed to reduce excess liquidity is the main policy implication of this chapter, since that may lead into a new wave of bad loans rather than impetus to economic activity.