Monetary Policy and Reserve Requirement in a DSGE Model with Financial Frictions

Abstract

This paper modifies the DSGE model of Gertler & Karadi (2011), which includes financial frictions on the balance sheet of the financial intermediaries, to introduce reserve requirements that must be held at the Monetary Authority and a confidence shock in the financial system. We analyzed the impacts of those changes on the transmission channels of the monetary policy. The results indicate that the presence of reserve requirements amplifies the transmission of monetary policy by the credit channel, increasing the leverage of banks when the interest rate falls and decreasing otherwise. The decline in the credit level when the interest rate is increased can be counterbalanced by a macroprudential policy that adjusts the reserve requirements based on a rule which depends on deviations of the credit from the steady state. However, reserve requirements should not replace the interest rate as the most adequate monetary policy instrument for inflation stabilization