Is the Impact of an Unexpected Positive Required Reserves Ratio Shock on Inflation Expectations Different from That Due to Positive Excess Liquid Asset Holdings and Forex Reserves Shock?

This chapter explores the interaction of various monetary and macro-prudential tools and their effects on the macro-economy and the price stability mandate. We assess the different effects of the tightening in the banks’ required reserves (RR) ratio, an unexpected increase in excess liquid asset holdings (LAH) and the accumulation of foreign currency reserves on inflation expectations. The chapter also assesses whether these monetary and macro-prudential tools complement or propagate each other’s effects on inflation expectations. Evidence shows that positive RR ratio, excess LAH and forex reserves accumulation shocks lower inflation expectation across all maturities. Nonetheless, the decline is more pronounced in current inflation expectations compared to the one-year and two-year ahead inflation expectations. The R/US$ and the nominal effective exchange rates (NEER) play a significant role in transmitting the positive shocks to the RR ratio, excess LAH and forex reserves on inflation expectations. But inflation expectations decline more due to an unexpected increase in the RR ratio compared to a positive excess LAH shock. We conclude that all three shocks complement and propagate each other’s effects on inflation expectations in the same direction. But the RR ratio tightening shocks exert the most potent shock effects on current inflation expectations and the R/US$ exchange rate plays a meaningful role in propagating these tightening effects. This is because the RR ratio tightening shock dampens credit-demand-driven inflation shocks.