Effectiveness of reserve requirements on current account imbalances

Abstract

Following the recent financial crisis, reserve requirements have become a policy instrument preferred in many emerging markets such as China, Brazil and Turkey for various purposes. Therefore, the formulating a theoretical framework to study the policy effectiveness remains an important issue. In this thesis, I develop a DSGE model with the financial accelerator mechanism so as to see the effectiveness of reserve requirement in small open economies, especially in influencing the external imbalances. External imbalances can either be interpreted as current account imbalances or its mirroring capital account imbalances. The main channel through which the external balances play a role is via the banking sector, which is modelled as engaging in international borrowing. This framework allows examination of the responses of the external imbalances to shocks to the reserve requirement ratio As a result, higher reserve requirements make domestic borrowing cheaper than foreign borrowing and by this way, changes in net foreign liabilities create a current account surplus. Thus, a country with current account deficit can use reserve requirements to readjust its external imbalances.