The impact of reserve requirements on macroeconomic and financial stability in a small open economy

This paper examines the impact of changes in differentiated reserve requirement rates on inflation, the banking sector, and real macroeconomic variables in a financially dollarized economy, using a New Keynesian dynamic stochastic general equilibrium model designed for a small open economy. The model incorporates nominal price rigidities, labor and financial market frictions, and liability dollarization. It is calibrated using quarterly data for Armenia from 2005Q1 to 2022Q4 to investigate how variations in differentiated reserve requirement rates affect the real economy. Simulations of monetary policy and reserve requirement shocks indicate that a contractionary monetary shock increases financial dollarization, whereas a reserve requirement shock reduces it. The impact of the reserve requirement changes on inflation remains relatively small. When various scenarios of differentiated reserve requirement rates are combined with a contractionary monetary policy shock, domestic and foreign currency deposit volatility stabilizes, leading to reduced financial dollarization, although volatility in lending and the output gap increases. Despite this trade-off in a dollarized economy, using differentiated reserve requirement rule can enhance overall macroeconomic and financial stability. This is supported by results from the evaluation of the Central Bank of Armenia's loss functions, which suggest that differentiated reserve requirement rates can complement monetary policy and effectively serve countercyclical regulation purposes in a financially dollarized economy.