The Relationship Between the Output Gap and Excess Liquidity : Evidence From Czech Republic, Estonia and Kosovo

Banks in European Transition Economies are proportionally lending less than their counterparts in the Eurozone in the face of seemingly profitable loan opportunities, whilst apparently continuously holding excess liquidity. The question that arises is whether banks in European Transition Economies are persistently accumulating costly excess liquidity and whether that widens the output gap? This study is novel in two respects. Firstly, assuming endogeneity, a new conceptual relationship between output gap and excess liquidity is presented. Secondly, empirical evidence is presented using the system equation method Seemingly Unrelated Regression, not previously used in this context. The results indicate that rather than being in a causal relationship, excess liquidity and the output gap are found to be correlated via common observed and unobserved determinants. The most important policy implication of this research is that since the relationship between output gap and excess liquidity is not causal, reducing excess liquidity will not necessarily lead to a smaller (negative) output gap. There seems to be no straightforward policy framework informed by a clear trans-mission mechanism from excess liquidity to output gap