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Abstract: This paper presents a small open economy model to analyze the role of central bank liquidity management in implementing "unconventional" monetary policies within an inflation targeting framework. In particular, the paper explicitly models the facilities that the central bank uses to manage liquidity in the economy, which creates a role for the central bank balance sheet in equilibrium. This permits the analysis of two "unconventional" policies: sterilized exchange-rate interventions and expanding the list of eligible collaterals accepted at the liquidity facilities operated by the central bank. These policies have been recently implemented by several central banks: the former as a way to counteract persistent appreciations in the domestic currency, and the latter as a response to the recent global financial crisis in 2008. As a case study, the paper provides a detailed account of the Chilean experience with these alternative tools, as well as a quantitative evaluation of the effects of some of these policies

Central banks that work under an inflation-targeting regime generally use an interest rate as the main instrument to implement monetary policy. The latter can be denominated conventional monetary policy. Central banks often deviate from this practice, however, and engage in other policies to deal with particular situations. As these alternatives depart from the usual practice, they are generally labeled "unconventional" policies. During the recent global financial crisis and recession of 2008–09, central banks around the world and in Latin America, in particular, responded to external shocks in a variety of ways. Canales-Kriljenko and others provide a precise description of how different Latin American central banks reacted to the U.S. financial crisis shock in 2008, with an emphasis on the heterogeneity in the use of unconventional monetary policy instruments. For example, while Colombia and Peru lowered reserve requirements in their banking systems, the Central Bank of Chile relaxed the collateral requirements for repurchase (repo) transactions. Also, Chile and Peru extended the repayment period in repo transactions.

We empirically analyse the relationship between longer term central bank liquidity support and banks' balance sheet ratios, using difference-in-differences panel regressions and propensity score matching on a large sample of banks in the euro area. The research question is whether the liquidity operations, which were introduced to prevent disorderly deleveraging, can also be linked to unintended changes in banks' funding policies and asset allocations. The results show that unconditional and conditional refinancing operations are associated with different developments on banks' balance sheets. Unconditional longer-term refinancing operations went together with higher maturity transformation by banks in stressed countries, and also more carry trades, i.e. banks borrowing more while increasing their holdings of government bonds. In contrast, refinancing operations that were conditional on banks' lending were not associated with such carry trades, highlighting the benefits of conditionality attached to long-term refinancing operations.