Required Reserves as a Credit Policy Tool (with Yasin Mimir and Temel Taşkın)

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.