External shocks, financial volatility and reserve requirements in an open economy

The performance of a simple, 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. An optimal, credit-based reserve requirement rule, based on minimizing a composite loss function, 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. Greater reliance on sterilization implies a less aggressive optimal reserve requirements rule, implying that the two instruments are partial substitutes.