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External Shocks, Financial Volatility and Reserve Requirements in an Open Economy

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  • Pierre-Richard Agénor
  • K. Alper
  • L. Pereira da Silva

Abstract

The performance of a countercyclical reserve requirement rule is studied in a dynamic stochastic model of a small open economy with financial frictions, imperfect capital mobility, a managed float regime, and sterilized foreign exchange market intervention. Bank funding sources, domestic and foreign, are imperfect substitutes. The model is calibrated and used to study the effects of a temporary drop in the world risk-free interest rate. Consistent with stylized facts, the shock triggers an expansion in domestic credit and activity, asset price pressures, and a real appreciation. A credit-based reserve requirement rule helps to mitigate both macroeconomic and financial volatility, with the latter defined both in terms of a narrow measure based on the credit-to-output ratio, the ratio of capital flows to output, and interest rate spreads, and a broader measure that includes real asset prices as well. An optimal rule, based on minimizing a composite loss function, is also derived. Sensitivity tests, related to the intensity of sterilization, the degree of exchange rate smoothing, and the rule used by the central bank to set the cost of bank borrowing, are also performed, both in terms of the transmission process and the optimal rule

Suggested Citation

  • Pierre-Richard Agénor & K. Alper & L. Pereira da Silva, 2015. "External Shocks, Financial Volatility and Reserve Requirements in an Open Economy," Working Papers Series 396, Central Bank of Brazil, Research Department.
  • Handle: RePEc:bcb:wpaper:396
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    1. Primus, Keyra, 2017. "Excess reserves, monetary policy and financial volatility," Journal of Banking & Finance, Elsevier, vol. 74(C), pages 153-168.

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    JEL classification:

    • E32 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles - - - Business Fluctuations; Cycles
    • E58 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Central Banks and Their Policies
    • F41 - International Economics - - Macroeconomic Aspects of International Trade and Finance - - - Open Economy Macroeconomics

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