Liquidity Regulation, Monetary Policy and Welfare

Abstract

In the aftermath of the Great Recession, when various policies for regulating credit liquidity were introduced, the US Fed and other central banks placed more emphasis on the interest on reserves than the more traditional required reserve ratio. This paper employs a model with endogenous credit risk, a balance sheet channel, a cost channel and bank equity requirements, to examine the macroprudential role of the interest on reserves and the required reserve ratio and compare their welfare implications. Two transmission channels are identified, the deposit rate and the balance sheet channels. The required reserve ratio is shown to have conflicting effects through these two channels mitigating its policy effectiveness as a credit regulation tool. Conversely, with the interest on reserves both these channels complement each other in reducing the output gap, the cost channel and inflation. The results show that as a credit regulation tool the interest on reserves requires lower policy rate intervention and yields superior welfare outcomes to both the required reserve ratio and credit-augmented Taylor rules.