Abstract:
This paper conducts a quantitative investigation of the role of reserve requirements as a
credit policy tool. We build a monetary 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 which 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. Time-varying RRR policy
reduces 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.