Reserve requirements vs interest on reserves in a closed economy
In a standard banking framework in which banks invest insufficiently in short-term assets under laissez faire, does a policy of a reserve requirement on banks or one that pays interest on reserves more efficiently increase liquidity?
Davide Porcellacchia in this paper modifies the Diamond-Dydvig (1983)1 model by allowing consumers to invest directly in financial markets in addition to investing their wealth solely in bank deposits. He finds that in this set up a reserve requirement does increase the share of the banks’ asset portfolio invested in short-term assets but it also makes consumers decide to hold fewer deposits. As a result, these two effects cancel each other out in such a way so that aggregate investment in short-term assets remains unchanged. On the other hand, in a model where the extent of intermediation ex ante is fixed, the payment of interest on reserves can increase banks short-term asset holdings by making these assets relatively more remunerative:
The paper’s key conclusion is that interest on reserves is effective at promoting liquidity-risk insurance. It is a superior policy to the setting of a reserve requirement, because it does not lead to financial disintermediation.
Since payment of interest on reserves has a fiscal cost and therefore distortionary taxation implies a lower optimal level of interest on reserves.
Paying Interest on Reserves to Promote Liquidity
Author: Davide Porcellacchia
From: ECB
Reserve requirements vs interest on reserves in an open economy
Chi et al. in this paper look at an economy a) with a pecuniary externality arising from a collateral constraint on private borrowing; b) in which foreign lending to households is intermediated by domestic banks; and b) the government has access to capital controls and interest on bank reserves. They argue that in this case the economy underborrows as compared to a setting where bank intermediation is absent and the economy ends up overborrowing. Their model specification follows Cúrdia and Woodford (2011)2 in modelling bank lending and Mendoza (2002)3, Bianchi (2011)4, and Korinek (2011)5 in modelling an open economy with a flow collateral constraint.
A novel result of the paper is that the optimal interest-on-reserve policy is able to circumvent not only the banking friction but also the collateral constraint friction. In fact, the optimal bank-reserve remuneration policy achieves the first-best allocation. The first-best allocation is the allocation that solves the problem of maximizing household welfare subject to the economy’s resource constraint and to a natural debt limit. That is, the first-best allocation is the competitive equilibrium corresponding to an economy without any financial frictions (banks or collateral constraints). In this equilibrium, the central bank floods the market with reserves, households demand no loans, and the interest rate on loans and deposits equals the world interest rate. Furthermore, capital controls are superfluous, as they are unnecessary to achieve the first-best allocation.
Optimal Bank Reserve Remuneration and Capital Control Policy
Authors: Chun-Che Chi, Stephanie Schmitt-Grohé, Martín Uribe
From: Institute of Economics, Academia Sinica, Columbia University
1.Diamond, Douglas W, and Philip H Dybvig. 1983. “Bank Runs, Deposit Insurance, and Liquidity.” Journal of Political Economy, 91(3): 401–419.
2.Cúrdia, Vasco, and Michael Woodford, “The central bank balance sheet as an instrument of monetary policy,” Journal of Monetary Economics 58, January 2011, 54-79.
3.Mendoza, Enrique G., “Credit, Prices, and Crashes: Business Cycles with a Sudden Stop,” in Sebastian Edwards and Jeffrey A. Frankel (Eds.), Preventing Currency Crises in Emerging Markets, University of Chicago Press, Chicago, IL, 2002, 335-392.
4.Bianchi, Javier, “Overborrowing and Systemic Externalities in the Business Cycle,” American Economic Review 101, December 2011, 3400-3426.
5.Korinek, Anton, “Excessive Dollar Borrowing in Emerging Markets: Balance Sheet Effects and Macroeconomic Externalities,” University of Maryland, 2011.
