Working Paper Series no. 363: Reserve Requirements for Price and Financial Stability - When Are They Effective ?

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.
International Journal of Central Banking, (IJCB), March 2012, (forthcoming).

Christian Glocker and Pascal Towbin
February 2012

Classification JEL : E58, E52, F41, G18

Keywords : Reserve Requirements, Monetary Policy, Financial Stability, Capital Flows, Business Cycle