Excess Reserves, Monetary Policy and Financial Volatility

Primus, Keyra (2013): Excess Reserves, Monetary Policy and Financial Volatility.

Abstract

This paper examines the financial and real effects of excess reserves in a New Keynesian Dynamic Stochastic General Equilibrium (DSGE) model with monopoly banking, credit market imperfections and a cost channel. The model explicitly accounts for the fact that banks hold excess reserves and they incur costs in holding these assets. Simulations of a shock to required reserves show that although raising reserve require- ments is successful in sterilizing excess reserves, it creates a procyclical e¤ect for real economic activity. This result implies that financial stability may come at a cost of macroeconomic stability. The findings also indicate that using an augmented Taylor rule in which the policy interest rate is adjusted in response to changes in excess re- serves reduces volatility in output and inflation but increases fluctuations in financial variables. To the contrary, using a countercyclical reserve requirement rule helps to mitigate fluctuations in excess reserves, but increases volatility in real variables.

• Item Type: MPRA Paper
• Language: English
• Keywords: Excess Reserves, Reserve Requirements, Countercyclical Rule
• Subjects: E - Macroeconomics and Monetary Economics > E4 - Money and Interest Rates; E - Macroeconomics and Monetary Economics > E5 - Monetary Policy, Central Banking, and the Supply of Money and Credit; E - Macroeconomics and Monetary Economics > E5 - Monetary Policy, Central Banking, and the Supply of Money and Credit > E52 - Monetary Policy; E - Macroeconomics and Monetary Economics > E5 - Monetary Policy, Central Banking, and the Supply of Money and Credit > E58 - Central Banks and Their Policies

References

[1] Agénor, Pierre-Richard, Joshua Aizenman and AlexanderW. Ho¤maister (2004), "The Credit Crunch in East Asia: What can Bank Excess Liquid Assets tell us?," Journal of International Money and Finance, Vol. 23, pp. 27-49.

[2] Agénor, Pierre-Richard and Koray Alper (2012), "Monetary Shocks and Central Bank Liquidity with Credit Market Imperfections," Oxford Economic Papers, Vol. 64, 563- 91.

[3] Agénor, Pierre-Richard, Koray Alper and Luiz Pereira da Silva (2013), "Capital Reg- ulation, Monetary Policy and Financial Stability," forthcoming, International Journal of Central Banking.

[4] Agénor, Pierre-Richard (2012), "Capital Requirements and Business Cycles with Credit Market Im- perfections," Journal of Macroeconomics, Vol. 34, pp. 687-705.

[5] Agénor, Pierre-Richard and Karim El Aynaoui (2010), "Excess Liquidity, Bank Pricing Rules, and Monetary Policy," Journal of Banking and Finance, Vol. 34, pp. 923-33.

[6] Agénor, Pierre-Richard and Peter J. Montiel (2008), "Monetary Policy Analysis in a Small Open Credit-Based Economy," Open Economies Review, Vol. 19, pp. 423-55.

[7] Aikaeli, Jehovaness (2006), "Determinants of Excess Liquidity in Tanzanian Commercial Banks," University of Dar es Salaam. Retrieved at http://papers.ssrn.com/sol3/papers.cfm?abstract_id=971750.

[8] Akinboade, Oludele Akinloye and Frederick B. Max Zachariah (1997), "Excess Liq- uidity in the Botswana Banking System and Short-Term Strategies for Controlling it," African Review of Money Finance and Banking, No. 1/2, pp. 123-39.

[9] Anderson-Reid, Karen (2011), "Excess Reserves in Jamaican Commercial Banks: The Implications for Monetary Policy," Working Paper, Bank of Jamaica.

[10] Areosa, Waldyr Dutra and Christiano Arrigoni Coelho (2013), "Using a DSGE Model to Assess the Macroeconomic E¤ects of Reserve Requirements in Brazil," Working Paper No. 303, Central Bank of Brazil.

[11] Ashcraft, Adam, James McAndrews and David Skeie (2009), "Precautionary Reserves and the Interbank Market," Sta¤ Report No. 370, Federal Reserve Bank of New York.

[12] Baltensperger, Ernst (1980), "Alternative Approaches to the Theory of the Banking Firm," Journal of Monetary Economics, Vol. 6, pp. 1-37.

[13]Baltensperger, Ernst (1982), "Reserve Requirements and Economic Stability," Journal of Money,Credit and Banking, Vol. 14 (2), pp. 205-15.

[14] Bathaluddin, Barik M., Nur M. Adhi P. and Wahyu A. W. (2012), "The Impact of Excess Liquidity on Monetary Policy," Bulletin of Monetary Economics and Banking,Vol. 14 (3), pp. 245-67.

[15] Central Bank of Trinidad and Tobago (2005), "The Implementation of Monetary Pol-icy in Trinidad and Tobago," Public Education Pamphlet Series No. 1, Central Bank of Trinidad and Tobago.

[16] Central Bank of Trinidad and Tobago (2007), Monetary Policy Report (MPR), Central Bank of Trinidad and Tobago.

[17] Christiano, Lawrence, Roberto Motto and Massimo Rostagno (2010), "Financial Factors in Economic Fluctuations," Working Paper No. 1192, European Central Bank.

[18] Deléchat, Corinne, Camila Henao, Priscilla Muthoora and Svetlana Vtyurina (2012),"The Determinants of Banks Liquidity in Central America," Working Paper, No. 301, International Monetary Fund.

[19] Dixit, Avinash K. and Joseph E. Stiglitz (1977), "Monopolistic Competition and Optimum Product Diversity," The American Economic Review, Vol. 67 (3), pp. 297-308.

[20] Ennis, Huberto M. and John A. Weinberg (2007), "Interest on Reserves and Daylight Credit," Federal Reserve Bank of Richmond, Economic Quarterly, Vol. 93 (2), pp.111-42.

[21] Ennis, Huberto M. and Alexander L. Wolman (2012), "Large Excess Reserves in the U.S.: A View from the Cross-Section of Banks," Working Paper No. 12-05, FederalReserve Bank of Richmond.

[22] European Central Bank (2008), Monthly Bulletin, European Central Bank.

[23] Fielding, David and Anja Shortland (2005), "Political Violence and Excess Liquidity in Egypt," The Journal of Development Studies, Vol. 41 (4), pp. 542-57.

[24] Galí, Jordi (2008), Monetary Policy, Inflation, and the Business Cycle: An Introduction to the New Keynesian Framework, Princeton University Press.

[25] Ganley, Joe (2004), "Surplus Liquidity: Implications for Central Banks," Lecture Series No. 3, Centre for Central Banking Studies, Bank of England.

[26] Glocker, Christian and Pascal Towbin (2012), "Reserve Requirements for Price and Financial Stability: When are they E¤ective?," International Journal of Central Banking, Vol. 8 (1), pp. 65-114.

[27] Goodfriend, Marvin (2002), "Interest on Reserves and Monetary Policy," Federal Reserve Bank of New York Economic Policy Review, Vol. 8 (1), pp. 77-84.

[28] Gray, Simon (2011), "Central Bank Balances and Reserve Requirements," Working Paper No. 36, International Monetary Fund.

[29] Heenan, Geo¤rey (2005), "Dealing with Excess Liquidity," Presentation tothe Joint Africa Institute. Retrieved at http://www.powershow.com/view/21ef15- ZTA3Z/Dealing_with_Excess_Liquidity_powerpoint_ppt_presentation.

[30] Hilton, Spence and James McAndrews (2010), "Challenges and Lessons of the Federal Reserves Monetary Policy Operations during the Financial Crisis," Federal Reserve Bank of New York.

[31] Horrigan, Brian R. (1988), "Are Reserve Requirements Relevant for Economic Stabi-lization?," Journal of Monetary Economics, Vol. 21 (1), pp. 97-105.

[32] Jallath-Coria, Eduardo, Tridas Mukhopadhyay and Amir Yaron (2005), "How well do Mexican Banks Manage their Reserves?," Journal of Money, Credit, and Banking, Vol. 37 (4), pp. 623-43.

[33] Jayaraman, T.K. and Chee-Keong Choong (2012), "Implications of Excess Liquidity in Fiji's Banking System: An Empirical Study," Paper No. 43505, Munich Personal RePEc Archive (MPRA).

[34] Jenkins, Brian C. (2010), "The Bank Lending Channel and Monetary Policy Trans-mission when Banks are Risk Averse," Working Paper, University of North Carolina, Chapel Hill.

[35] Jordan, Alwyn , Sharon Branch, Andrea McQuay, Yvonne Cooper and Latoya Smith(2012), "An Analysis of Bank Liquidity in The Bahamas (2001-2012),"Working Paper, The Central Bank of The Bahamas.

[36] Kashyap, Anil K. and Jeremy C. Stein (2012), "The Optimal Conduct of Monetary Policy with Interest on Reserves," American Economic Journal: Macroeconomics, Vol.4 (1), pp. 266-82.

[37] Keen, Benjamin and Yongsheng Wang (2007), "What is a Realistic Value for Price Adjustment Costs in New Keynesian Models?," Applied Economics Letters, Vol. 14, 789-93.

[38] Keister, Todd, Antoine Martin and James McAndrews (2008), "Divorcing Money from Monetary Policy," Federal Bank of New York, Economic Policy Review, Vol. 14 (2), pp. 41-56.

[39] Keister, Todd and JamesMcAndrews (2009), "Why are Banks Holding so Many Excess Reserves?," Sta¤ Report No. 380, Federal Reserve Bank of New York.

[40] Khemraj, Tarron (2007), "Monetary Policy and Excess Liquidity: The Case of Guyana," Social and Economic Studies. Vol. 56 (3), pp. 101-27.

[41] Khemraj, Tarron (2009), "Excess Liquidity and the Foreign Currency Constraint: The Case of Monetary Management in Guyana," Applied Economics, Vol. 41 (16), pp. 2073-84.

[42] Lebedinski, Lara (2007), "Excess Liquidity and Monetary Policy Under Fixed Ex-change Rates: A Theoretical and Empirical Investigation," MSc Dissertation, Univer- sity of Manchester, United Kingdom.

[43] Lee, Jang-Yung (1997), "Sterilizing Capital Inflows," Economic Issues 7, International Monetary Fund.

[44] Malikane, Christopher (2012), "Inflation Dynamics and the Cost Channel in Emerging Markets," Working Paper No. 42688, Munich Personal RePEc Archive (MPRA).

[45] Maynard, Tracy and Winston Moore (2005), "The Demand for Excess Liquid Assets in Barbados," Working Paper, Central Bank of Barbados.

[46] Meh, Césaire A. and Kevin Moran (2010), "The Role of Bank Capital in the Propa-gation of Shocks," Journal of Economic Dynamics and Control, Vol. 34, pp. 555-76.

[43] Lee, Jang-Yung (1997), "Sterilizing Capital Inflows," Economic Issues 7, International Monetary Fund.

[44] Malikane, Christopher (2012), "Inflation Dynamics and the Cost Channel in Emerging Markets," Working Paper No. 42688, Munich Personal RePEc Archive (MPRA).

[45] Maynard, Tracy and Winston Moore (2005), "The Demand for Excess Liquid Assets in Barbados," Working Paper, Central Bank of Barbados.

[46] Meh, Césaire A. and Kevin Moran (2010), "The Role of Bank Capital in the Propa- gation of Shocks," Journal of Economic Dynamics and Control, Vol. 34, pp. 555-76.

[47] Montoro, Carlos and Ramon Moreno (2011), "The Use of Reserve Requirements as a Policy Instrument in Latin America," Quarterly Review, Bank for International Settlements.

[48] Morrison, George R. (1966), Liquidity Preferences of Commercial Banks, University of Chicago Press, Chicago.

[49] Nyawata, Obert (2012), "Treasury Bills and/or Central Bank Bills for Absorbing Surplus Liquidity: The Main Considerations," Working Paper No. 40, International Monetary Fund.

[50] Pontes, Gentil and Fátima Teresa Sol Murta (2012), "The Determinants of the Bank's Excess Liquidity and the Credit Crisis: The Case of Cape Verde," Retrieved at http://www.alde.es/encuentros/anteriores/xveea/trabajos/p/pdf/132.pdf.

[51] Poole, William (1968), "Commercial Bank Reserve Management in a Stochastic Model: Implications for Monetary Policy," The Journal of Finance, Vol. 23 (5), pp. 769-91.

[52] Primus, Keyra (2012), "Monetary Policy, Excess Liquidity and Policy Rules: The Case of Trinidad and Tobago," Working Paper.

[53] Primus, Keyra, Anthony Birchwood and Lester Henry (forthcoming), "The Dynam-ics of Involuntary Commercial Banks' Reserves in Trinidad and Tobago," Journal of Developing Areas.

[54] Robitaille, Patrice (2011), "Liquidity and Reserve Requirements in Brazil," Interna-tional Finance Discussion Papers, No. 1021, Board of Governors of the Federal Reserve System.

[55] Rotemberg, Julio J. (1982), "Monopolistic Price Adjustment and Aggregate Output," The Review of Economic Studies, Vol. 49 (4), 517-31.

[56] Samake, Issouf (2010), "A Macro Model of the Credit Channel in a Currency Union Member: The Case of Benin," Working Paper No. 191, International Monetary Fund.

[57] Saxegaard, Magnus (2006), "Excess Liquidity and E¤ectiveness of Monetary Policy: Evidence from Sub-Saharan Africa," Working Paper No. 115, International Monetary Fund.

[58] Sol Murta, Fátima Teresa and Ana Margarida Garcia (2009), "The Demand for Ex- cess Reserves in the Euro Area and how the Current Credit Crisis Influences it," Grupo de Estudos Monetários e Financeiros Faculdade de Economia da Universidade de Coimbra.

[59] Tabak, Sule Senel and Turkiye Cumhuriyet Merkez Bankasi (2006), "Turkey: Causes and Management of Surplus Liquidity," in Simon T. Gray, Central Bank Management of Surplus Liquidity, Handbooks in Central Banking, Lecture Series No. 6, Centre for Central Banking Studies, Bank of England.

[60] Taylor, John B. (1993), "Discretion versus Policy Rules in Practice," Carnegie-Rochester Conference Series on Public Policy, Vol. 39, pp. 195-214.

[61] The World Bank (2012), World Development Indicators, The World Bank.

[62] Tovar, Camilo E., Mercedes Garcia-Escribano and Mercedes Vera Martin (2012), "Credit Growth and the E¤ectiveness of Reserve Requirements and Other Macropru- dential Instruments in Latin America," Working Paper No. 142, International Monetary Fund.

[63] Walsh, Carl E. (2010), Monetary Theory and Policy, Third edition, The MIT Press Cambridge, Massachusetts.