Central Bank Bills and the Exchange Rate: The Case of Papua New Guinea

This paper presents a simple model of how the sale of central bank bills (CBBs) serves as an effective tool of exchange rate management in the case of Papua New Guinea. We employ a VAR approach and find that the quantity of CBBs rather than the short-term interest rate elicits the largest movement in the exchange rate. Moreover, we find evidence that banks hold non-remunerated excess reserves at a non-zero lower bound rate of interest. This is indirect evidence that policymakers must sterilize excess reserves not for fear of losing control of interest rate but for exchange rate management. Our model and empirical results make a strong case that the sale of CBBs can simultaneously support exchange rate stability and money-financed fiscal deficits. The CBBs help to quarantine the excess reserves injected through monetary financing