| Summary: | This paper aims to answer the question of what kind of liquidity management system would be optimal for Iceland with respect to two important considerations. One is the current environment of surplus reserves and the other is Iceland’s specific character of being a very small, significantly open economy, with its own currency. The paper takes note of the fact that implementation of monetary policy underwent significant changes at central banks in many countries following the Global Financial Crisis (GFC). In many cases, this went hand in hand with efforts to avert an even more severe recession through exceptional provision of liquidity, often leading to implementation of monetary policy under the conditions of a significant structural surplus of reserves. As in Iceland, the response was in a number of cases, a move to a de facto floor system. The crisis gave central banks in many countries a welcome opportunity to reflect on their operational frameworks, and this seems sensible for Iceland too, at the current juncture. To better understand the recent developments and consider the way forward as regards liquidity management, the paper looks at the theory behind monetary policy implementation. The various origins of surplus reserves, their characteristics and the implications for conduct of monetary policy are discussed in some detail. The reasons for the steep accumulation of surplus reserves in the Icelandic banking system are considered and fluctuations are found to be likely to persist in a small, open economy, not least one with a managed float. Four different types of liquidity management systems at central banks are considered in turn; a wide corridor with reserve averaging, a narrow corridor without reserve averaging, a floor system and a quota system. Through the comparison of these liquidity managements systems as well as operational realities in selected economies, notably the neighbouring countries of Sweden, Norway and Denmark, we reflect on whether other approaches might better serve a small, open ...
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