The Reserve requirement as a policy instrument in a small open economy with fixed exchange rates

Abstract

In this paper we examine the reserve requirement as an instrument of monetary policy in a small open economy with perfect capital mobility and a fixed exchange rate. The deposit rate is assumed to be institutionally fixed. The analysis is carried out using a Tobin-Brainard type portfolio model. In the long run the reserve requirement and open market operations are effective policy instruments. For restrictive policy, the reserve requirement may be considered more effective than open market operations; the reserve holds for expansionary policy. Financial innovations which allow the banks to avoid the reserve requirement reduce the effectiveness of the reserve requirement but increase the effectiveness of open market operations. An increase in the required reserve ratio was found to dampen the effects of open market operations.