Optimal Bank Reserve Remuneration and Optimal Capital Control Policy

Abstract

This paper addresses the question of how central banks should conduct bank reserve remuneration policy in open economies. The analytical framework is a model with a banking channel and a collateral constraint that limits household debt by a fraction of income. The paper finds that under the optimal reserve remuneration and capital control policy, bank reserves are countercyclical. By expanding bank reserves during episodes in which the household collateral constraint binds or is close to binding, the government allows the economy to continue to have access to external funding in spite of the fact that households are being forced to deleverage. In this regard, bank reserves act as a cushion between external debt and household debt. As a consequence, external debt is higher than in the absence of government intervention. That is, the unregulated economy borrows too little relative to what is optimal. This result contrasts with the standard overborrowing result obtained in this class of models in the absence of a banking channel. Finally, the paper shows that bank-reserve remuneration welfare dominates reserve requirements.