Required reserves as a credit policy tool

Abstract

This paper quantitatively investigates the role of reserve requirements as a credit policy tool. We build a monetary dynamic stochastic general equilibrium (DSGE) model with a banking sector in which an agency problem between households and banks leads to endogenous capital constraints for the latter. In this setup, a countercyclical required reserves ratio (RRR) rule that responds to expected credit growth is found to countervail the negative effects of the financial accelerator mechanism triggered by productivity and bank capital shocks. Furthermore, it reduces the procyclicality of the financial system compared to a fixed RRR policy regime. The credit policy is most effective when the economy is hit by a financial shock. A time-varying RRR policy reduces the intertemporal distortions created by the fluctuations in credit spreads at the expense of generating higher inflation volatility, indicating an interesting trade-off between price stability and financial stability.

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