Optimal Reserve Requirements and Price Stability: Taiwan's Case Study

This paper presents a stochastic financial model from which one can derive the optimal reserves ratio for stabilizing price level. It is shown that the optimal reserves ratio is a function of the structure of unanticipated shocks to a liquid asset market and a high-powered money market. An important policy implication, drawn from this model, suggests that it may help the stabilization of price level if a lower level of the reserve requirements is adopted by the central bank when the shock exists solely in a liquid asset market. An application of the presented model to the financial assets in Taiwan suggests that the optimal reserves ratio for stabilizing the price level is approximately 5.7717 percent, in the case of the 2-SLS estimation, and 4.2442 percent, in the case of the SUR estimation, below the weighted average of the actual 7.7575 percent up to the end of 1997. The empirical findings further suggest Taiwan's monetary authority would thus have to accept a lower level of the reserve requirements in order to reduce the price fluctuations. I. INTRODUCTION Reserve requirements have become a common institutional feature of our monetary system since the system was first introduced in the 19th century. Reserve requirements are generally defined as a system mandating banks and other depository institutions to maintain vault cash of deposits held with a central bank balance as a reserve at a fractional percentage (reserve ratio) against their liabilities. Since the 1940s, the use of reserve requirements as a monetary policy instrument has been widely adopted by most of the countries in the world. Up to the recent decade, however, the use of reserve requirements has undergone two significant and substantial changes. First, with regard to the reforms of the reserve requirement system, it appears to have converged in the direction of simplification and reduction in order to reduce the regulatory burdens on subjected banks arising from reserve requirements. For example, the central banks in the major industrialized countries (e.g., Canada, France, Germany, Italy, Japan, United Kingdom, and United States) have reduced their reserve ratios as well as simplifying reserve ratio trenches over the past decade in an attempt to lighten the burden they placed on banks. This convergence suggests that a market-based policy strategy for the reserve requirement system is now likely to be a general trend. Second, since the 1980s, due to financial liberalization and innovation along with regulatory and technological change, the relationship between the growth rate of monetary aggregates and economic growth in some countries has become less stable. It has led to a reconsideration of the usefulness of money supply as the policy objectives and has altered the operating philosophy for a central bank's policy tools. For example, to date during the 1990s, a number of countries, (e.g., Australia, Canada, Finland, Israel, New Zealand, Spain, Sweden and United Kingdom) have instead begun directly targeting the inflation rate. Indeed, because almost all central banks now identify price stability as the primary objective of monetary policy, in classifying policy framework it is probably more helpful to look at how specific a country's inflation objective is, rather than to distinguish between intermediate and final-target countries. Particularly, in March of 1995, the Bank of England pioneerly held a conference for central banks from those countries currently using inflation targets. There appeared to be little agreement among researchers for a long time on either the optimal level of reserves or the criteria for setting such reserves in order to achieve macroeconomic stability. (See, e.g., Aschhein[2], Bryant[9], Carson[10], Friedman [13,14], Sellon, Gordon and Weiner[18], Van Hoose[22]) Several issues arose, and the literature is somewhat limited to conceptual and technical issues. One of the most issues is that the countries with inflation targets are often said to pursue final-target strategies because the end product of monetary policy actions are inflation outcomes. …

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