Based on a novel quarterly dataset for 52 countries for the period 1970-2011, we analyze the use and cyclical properties of reserve requirements (RR) as a macroeconomic stabilization tool and whether RR policy substitutes or complements monetary policy. We find that (i) around two thirds of developing countries have used RR policy as a macroeconomic stabilization tool compared to just one third of industrial countries (and no industrial country since 2004); (ii) most developing countries that rely on RR use them countercyclically; and (iii) in many developing countries, monetary policy is procyclical and hence RR policy has substituted monetary policy as a countercyclical tool. We interpret the latter finding as reflecting the need of many emerging markets to raise interest rates in bad times to defend the currency and not raise or lower the interest rate in good times to prevent further currency appreciation. Under these circumstances, RR policy provides a second instrument that substitutes for monetary policy. Evidence from expanded Taylor rules (i.e., Taylor rules that include a nominal exchange rate target) supports these mechanisms.
Keywords: macroprudential; reserve requirement; monetary policy; exchange rate; business cycle
Views expressed in the paper are those of the authors and do not necessarily reflect those of the Bank of Japan or Institute for Monetary and Economic Studies.