Reserve Requirements for Price and Financial Stability - When are They Effective?

TLDR

Reserve requirements are a prominent policy instrument in many emerging countries. The present study investigates the circumstances under which reserve requirements are an appropriate policy tool for price or financial stability. We consider a small open economy model with sticky prices, financial frictions, and a banking sector subject to legal reserve requirements, and compute optimal interest rate and reserve requirement rules. The study finds that reserve requirements aid price stability only when financial frictions are significant, provide notable benefits for financial stability, and are more effective than conventional interest rate policy when foreign currency debt is present.

Abstract

Reserve requirements are a prominent policy instrument in many emerging countries. The present study investigates the circumstances under which reserve requirements are an appropriate policy tool for price or financial stability. We consider a small open economy model with sticky prices, financial frictions and a banking sector that is subject to legal reserve requirements and compute optimal interest rate and reserve requirement rules. Overall, our results indicate that reserve requirements can support the price stability objective only if financial frictions are important and lead to substantial improvements if there is a financial stability objective. Contrary to a conventional interest rate policy, reserve requirements become more effective when there is foreign currency debt.