Optimal Bank Reserve Remuneration and Capital Control Policy

Abstract

This paper studies optimal capital-control and bank-reserve remuneration policy in an open economy with a banking channel and a collateral constraint that limits household debt by a fraction of income. It finds that the unregulated economy borrows too little relative to what is optimal (underborrowing). This finding contrasts with the standard overborrowing result obtained in the absence of a banking channel. Under optimal policy, the central bank injects bank reserves during recessions. In this way, the monetary authority is able to uncouple household deleveraging from economy-wide deleveraging, thereby ameliorating the severity of the financial crisis. The paper documents that in emerging and developed economies the lending spread (lending rate minus deposit rate) displayed a muted response during the 2007-2009 financial crisis. This fact is consistent with a decline in the demand rather than in the supply of loans and gives credence to models in which the collateral constraint is placed at the level of the nonfinancial sector as opposed to at the level of the bank. Institutional subscribers to the NBER working paper series, and residents of developing countries may download this paper without additional charge at www.nber.org.