Excess Reserves, Monetary Policy and Financial Volatility

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.