Monetary Policy and Reserve Requirements in a Small Open Economy

This paper investigates how a combination of monetary and macroprudential policies might affect the dynamics of a small open economy with financial frictions under alternative exogenous shocks. The proposed DSGE model incorporates macroprudential policy rules to the financial sector of an open economy. Exogenous shocks in productivity, domestic and foreign monetary policies are used to identify the roles of the macroprudential and monetary policies in stabilizing the economy. A welfare analysis compares the performance of alternative rules for reserve requirements. The model is calibrated for the Brazilian economy and results indicate the exchange rate plays a central role in the transmission of foreign shocks, but not of domestic shocks. Considering the volatility of the variables and convergence to steady state, the interest rate rule should target domestic inflation and not respond directly to the exchange rate. The reserve requirement rule, in its turn, should react countercyclically to the credit-gap and not have a fixed component. There is complementarity between monetary and macroprudential policies to stabilize the small open economy.