Question

Analyse the importance of implementing statutory reserve requirements (SRR) as means towards effective bank liquidity management and eventually the financial stability of a country. (750 - 900 words)

Answer 1

Reserve Requirements as an Instrument for Price and Financial Stability

Our analysis on the use of reserve requirements as a policy tool varies along three dimensions. The first dimension is the financial structure of the economy. We consider a first case where no financial frictions are present, apart from the assumption that savings have to be intermediated through banks and the requirement for banks to hold reserves. We then add a financial accelerator mechanism with domestic currency debt in the second case and with foreign currency debt in the third case.The second dimension is the central bank’s objective. In the first example, the central bank has the relatively standard objective of minimizing a weighted average of inflation and output variability; in the second example, the variability of loans enters additionally. The third dimension is operational: it includes the number of variables the central bank monitors and how it uses its instruments.

The main aim of this section is therefore to analyze to what extent the use of time-varying reserve requirements can improve policy outcomes, as the structure of the economy, the objective of the central bank, and the implementation of policy varies. In section 3.1 we analyze how the effects of discretionary changes in reserve requirements vary with other monetary arrangements and with the financial structure. The analysis of the transmission mechanism prepares the ground for the interpretation of the results in the subsequent sections.

The Effects of Discretionary Changes in Reserve Requirements

The present section discusses how the effects of reserve requirement shocks change with monetary policy and the financial structure. To simplify the discussion, we assume that reserve requirements follow an exogenous AR(1) process with autocorrelation 0.7 and we abstract from a systematic component in reserve requirement policy. We start by analyzing how the effects of changes in reserve requirements on the real economy depend on the use of other monetary policy instruments in an economy without a financial accelerator. Changes in reserve requirements can have two effects: First, they influence the money supply. For a given monetary base, higher reserve requirements imply smaller broad money aggregates and we expect an economic contraction. If the rate of reserve remuneration lies below the market interest rate, a second effect occurs: reserve requirements also act as a tax on the banking sector and drive a wedge between deposit rates and lending rates.

Under the interest rate rule, the effect as a tax on the banking sector dominates. If the central bank targets an interest rate, money becomes endogenous and changes in reserve requirements are accommodated. But higher reserve requirements increase the spread between lending and deposit rates. Under the interest rate rule, the deposit rate falls and the lending rate rises. A tightening through an increase in reserve requirements leads therefore to quite different effects than a tightening through an increase in the policy rate, which would raise the level of interest rates in general. The higher spread has two important consequences. The increase in the lending rate implies higher costs of credit for the real sector, which leads to a decline in investment and the capital stock. The fall in investment, however, does not necessarily lead to a decline in output, as there is also an effect on consumption and on exports. A decline in the deposit rate encourages consumption spending, as consumption is linked to the real deposit rate through the Euler equation.

Optimal Reserve Requirement Rules with a Price Stability

Objective In the present section we keep the objective fixed and consider only the price stability loss function defined in equation (18), while we vary the structure of the economy and the operational policy rules. We start with a situation where the central bank only monitors fluctuations in output and inflation and does not respond to loans (labeled setting A). The results are displayed in table 3. We report the optimized coefficients in the policy rules and the value of the resulting loss function—in particular, its absolute value and the value relative to a policy that keeps the exchange rate and the reserve requirement ratio (ςMP t ) constant.

Optimal Reserve Requirement Rules with a Financial Stability Objective

In this section we consider a case where the central bank explicitly wants to stabilize the fluctuations in loans, as reflected in the loss function LF S t in equation (19). The results are displayed in table 5. The optimal policy rules imply four key results: First, the use of reserve requirements as a policy tool leads to substantially lower loss function values, but only if there are financial frictions. Compared with policy C(III), the loss under policy C(I) rises by around 53 percent with domestic currency debt and by even more (89 percent) in the economy with foreign currency debt. For the foreign currency debt, the percentage reduction in the loss function corresponds to roughly 30 percent of the percentage reduction the United States has experienced in the corresponding loss function in the Great Moderation period.20 The higher loss under policy C(I) can be explained with the example of a technology shock as depicted in figure 5. The expansionary shock triggers a decline in inflation and an increase in loans. A policy aiming to stabilize inflation would favor a decline in the interbank interest rate in order to keep real rates low. The macroprudential policy, however, would favor an increase in the interbank rate which then attenuates credit demand of entrepreneurs. Hence, two goals should be implemented with one policy instrument: the interbank rate should increase and decrease at the same time. The final reaction of the interest rate will be such that it accommodates both policy goals imperfectly.