| Abstract | A notable hysteretic downward movement of the interest rates was observed when the money market rates underwent big fluctuations in 2013, which was hard to be explained by the traditional framework of liquidity supply and demand analysis. This paper, based on a theoretical analysis of the impact of monetary policy framework, the diversification of banks, shocks and central bank liquidity operations on the liquidity supply and demand, formulates a dynamic analysis framework from a micro perspective incorporating money market interest rates, the liquidity supply and demand, and the central bank liquidity management, and also conducts empirical studies based on Chinese date to reach the conclusion: the optimal policy choice of the central bank is to keep the interest rates below the reasonable level expected by the market via interest rate policies. And once the interest rates breach the reasonable upper limit, the central bank should immediately supply liquidity up to the threshold, meanwhile guide and stabilize market expectations, and mitigate the accelerating and hysteretic effects caused by the dynamic feedback between interest rates and liquidity supply and demand to bring down the interest rates. As there is no reverse causal links between the demand of banks to borrow from the central bank and the spread of the central bank Standing Lending Facility (SLF) and money market rates, the central bank should use the SLF as a main interest rate tool to regulate money market rates, enhance the transparency and applicability of the SLF, and specify the SLF rate at a fixed level instead of floating with money market rates. |