Reserve Requirements, Bank Runs, and Optimal Policies in Small Open Economies

Eduardo J.J. Ganapolsky
Working Paper 2003-39
December 2003

PDF iconDownload the full text of this paper in Adobe Acrobat 4.0 PDF format - (386 KB)

This paper rationalizes as the outcome of an optimal policy decision the pattern of reserve requirements and other macroeconomic variables in the aftermath of a bank run. The paper develops a general equilibrium model that departs from the standard small open economy (SOE) model in three dimensions: (i) capital mobility is not perfect, (ii) there exists a costly banking system, and (iii) there is an externality affecting individual banks’ decisions. The results suggest that the path of reserve requirements would depend on the type of shock that the economy receives and the effect that this shock produces on the interest rate. Interestingly, the size of the risk premium will affect the reaction of the economy to the shock. It is also shown that the dynamic adjustment will be slightly different for permanent and temporary shocks, and it will also depend on the access that the economy has to foreign funds.

JEL classification: E44, E58, F30, F41, G28

Key words: reserve requirements, optimal policy, financial crisis, emerging markets

The author thanks Amartya Lahiri, Martin Schneider, Carlos Végh, and seminar participants at UCLA, LAMES (San Pablo, 2002), and LACEA (Madrid, 2002) for their useful comments and suggestions. He also thanks Esteban Balseca for providing research assistance. The views expressed here are the author’s and not necessarily those of the Federal Reserve Bank of Atlanta or the Federal Reserve System. Any remaining errors are the author’s responsibility.

Please address questions regarding content to Eduardo J.J. Ganapolsky, Research Department, Federal Reserve Bank of Atlanta, 1000 Peachtree Street, NE, Atlanta, GA 30309-4470, 404-498-8785, 404-498-8058 (fax),