Working Papers

2016-10 | May 2017

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Reserve Requirements and Optimal Chinese Stabilization Policy

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We build a two-sector DSGE model to study the impact of reserve requirement adjustments, a frequently-used policy tool, for capital reallocation and business cycle stabilization in China. State-owned enterprises (SOEs) are financed by government-guaranteed bank loans, which are subject to reserve requirements, while private firms rely on unregulated “off-balance sheet” financing. Increasing reserve requirements taxes SOE activity and reallocates resources to private firms. This raises aggregate productivity, as SOEs are relatively unproductive, but increases the incidence of costly SOE failures. Under our calibration, optimal reserve requirement adjustments complement interest rate policy in maintaining macroeconomic stability and improving welfare.

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