Page 1

Multiple Reserve Requirements, Exchange Rates, Sudden Stops and Equilibrium

Dynamics in a Small Open Economy 

March 3, 2009

Wen-Yao Wang

Texas A&M University at Galveston

Paula Hernandez-Verme

Texas A&M University at College Station

Abstract

We model a typical Asian-crisis-economy using dynamic general equilibrium

techniques. Meaningful exchange rates obtain from nontrivial demands for fiat

currencies. Sudden stops/bank-panics are possible, and key for evaluating the

relative merits of alternative exchange rate regimes in promoting stability.

Strategic complementarities contribute to the severe indeterminacy of the

continuum of equilibria; there is a strong association between the scope for

existence and indeterminacy of equilibria, the properties along dynamic paths and

the underlying policy regime. Binding multiple reserve requirements reduce the

scope for financial fragility and panic equilibria; backing the money supply acts as

a stabilizer only in fixed regimes.

JEL Classification: E31, E44, F41

Keywords: Sudden stops; Exchange rate regimes; Multiple reserve requirements.

1. Introduction

We study the interaction between monetary policies and alternative exchange rate regimes to ascertain the

probability of a crisis, building from the characteristics of the Asian-crisis countries in 1997. Our broader goal

is to reinforce and fill in the link between the overexpansion of the financial system, banking crises, and

exchange rate regimes/monetary policy that we find lacking in the literature. With this in mind, we build a

Dynamic Stochastic General Equilibrium Model (DSGE) —from micro-foundations— replicating a small, open

economy (SOE) with a nontrivial banking system, such as one of the 1997 East Asian countries. Two words of

caution to the reader: First, this paper does not aim, from a historical point of view, to show the success of a

particular monetary policy in place either in defending the national currency or in managing contagion at the

time of the crisis. Our goal, instead, takes the form of a ―what if:‖ what if a typical Asian-crisis-country were

 We owe special thanks to David Bessler, Li Gan and Dennis Jansen for helpful comments and suggestions to previous versions

of this paper. We thank Teri Tenalio for her technical assistance. We would also like to thank the participants of the 2007

Midwest Macroeconomic Meetings for helpful suggestions, as well as the participants of the 2007 Southwestern Association

Meetings.

 Corresponding author. E-mail: wenyaowang@tamu.edu

 Corresponding author. E-mail: phernandez@econmail.tamu.edu

Page 2

to implement a policy of multiple reserve requirements with backing of the domestic money supply, and how

would it work under alternative exchange rate arrangements? Thus, we look forward and aim to suggest policy

options that may help these countries maintain stability in case a similar crisis was to hit again. Second, at this

time, we do not consider economic activity explicitly other than in the financial sector.

Our model captures all five stylized facts of the East Asian countries at the time of the crisis. It is

general knowledge that Indonesia, South Korea, and Thailand were the countries most affected by the East

Asian 1997/98 crisis, followed by Malaysia, Laos and the Philippines. There are five stylized facts shared by

these countries at the time of the crisis that we want to emphasize. 1) Increased risky-lending behavior by

banks led to a boom in private borrowing financed by non-performing loans1. 2) The lack of sound financial

structure worsened with the ill-oriented process of financial and capital liberalization2. 3) Banks’ financial

assets constituted the majority of their total assets –instead, for instance, of financing in capital markets. 4)

Borrowing from foreign banks was a significant portion of domestic banks’ loans. 5) The majority of these

countries had intermediate pegs in place. According to the standard chronology of the crisis, the floating of the

baht in July 1997 in Thailand triggered the crisis. A subsequent change in expectations led to the depreciation

of most currencies in the region, bank runs, rapid withdrawals of foreign capital —a sudden stop—and a

dramatic economic downturn followed. Unlike previous crises originated from fiscal imbalances and/or trade

deficits, the Asian crises shed light on the increased risky behavior and the overexpansion of the banking

system.

To build the framework that we just described, we used three building blocks that took us closer to our

goal systematically. In the first block, we model explicitly the behavior of individuals and obtain the micro-

foundations for our general equilibrium model. In the second block, we introduce alternative exchange rate

regimes with their associated monetary policy rules. It is a well-established fact that for economies open to

international capital flows, the choice of exchange rate regime is central to explain the vulnerability and

fragility of financial markets, as well as domestic price stability and long-run viability. Tables 1.A and 1.B

summarize the exchange rate arrangements in the Asian countries. During most of the 1980s and the first part

of the 1990s, Indonesia, Korea, Thailand and Malaysia had managed floating arrangements —an intermediate

peg—, while Philippines had free floating. However, there were some important differences after the 1997

crises: Philippines continued with free floating, Indonesia, Korea and Thailand moved from intermediate pegs

to free floating as well, but Malaysia had a very hard peg in place. These facts make our comparison of the

relative merits of the two sets of policy rules relevant in the presence of binding multiple reserve requirements.

The third building block may allow one to infer behavior from a particular set

of circumstances: we may be able to separate and identify causes and

1 One may also think of this fact in the context of the subprime mortgage crisis that started in the second-part of 2007 in the U.S.

2 See Lindgren et al (1999) and Kishi and Okuda (2001).

Page 3

consequences by studying separately and jointly the main stylized facts of

sudden stops and bank-runs in similar economies3.

We consider two potential causes of crises: a crisis comes to our model either in the form of a sudden stop of

foreign credit (intrinsic uncertainty) or in the form of a panic among national depositors (extrinsic uncertainty.)

We put most of our effort on the distinguishing characteristic of the former but do not neglect the fact that a

self-fulfilling panic and run may implicitly aggravate a crisis.

We believe that we improve on C-V in at least three dimensions. First, C-V attached intrinsic value to

currencies they intended to be fiat4. We instead take multiple fiat currencies –domestic and foreign—a bit more

seriously, and introduce non-trivial demands for them. In particular, banks must hold a fraction of their

deposits as unremunerated currency reserves: a fraction to be held in the form of domestic currency and

another fraction in the form of foreign currency. Then, fiat money instead enters our model by the regulation

that governs the multiple reserve requirements in this economy5, the implications being that: 1) there is a

meaningful nominal exchange rate in our model, and 2) this nominal exchange rate will be determined

according to the exchange rate regime and the monetary policy in place. In second place, we use a DSGE

model in an economy with an infinite horizon, as is the OG. Thus, we are able to discuss the interesting

equilibrium dynamics defining each exchange rate arrangement, as opposed to both D-D and C-V. In third

place, we improve the way in which we introduce and treat potential crises, The potential for strategic

complementarities and the realization of self-fulfilling prophesies is ever present in alternative versions of the

OG model with outside assets in general, and models with one or more fiat currencies in particular6, and, of

course, in our model. In such contexts, the presence of informational and institutional frictions can exacerbate

situations that are already problematic, such as credit rationing, financial repression and endogenously arising

volatility, thus complicating the standard analysis of separating and pooling equilibria. Thus, the appropriate

utilization of the information and action sets available to agents at all points in time is critical. In this respect,

we reformulate the sequential checking constraint by depositors and devise a re-optimization problem by banks

after a sudden stop7.

Our results show the existence of a continuum of equilibria that are indeterminate in two ways: 1) an

allocation may be consistent with a continuum of relative price vectors, and 2) a vector of relative prices may

3 See Kaminsky (2003) for details.

4 In their model, people held domestic currency because they derived utility from it, which in itself attached intrinsic value to the

currency they intended to be fiat.

5 See Hernandez-Verme (2004) for the original discussion.

6 The recent literature on open economy macroeconomics has used intensively self-fulfilling prophecies as a tool that may lead to

very important underlying explanations for financial fragility, currency crises and/or speculative attacks. See Cole and Kehoe

(1996) and Obstfeld (1996).

7 In particular, one argument of the C-V framework was that when the probability of a crisis is public information, each agent in

this economy must use this information when contemplating optimal plans of action at the beginning of every date, and, as result,

the optimal behavior of agents is invariant with respect to whether the crisis was realized or not. Alternatively, we introduce the

potential for uncertainty of the crisis by using a sunspot variable: a random variable unconnected to the fundamentals of the

economy and that expresses the extrinsic uncertainty.

Page 4

be consistent with several different allocations. There is a strong association between the scope for existence

and indeterminacy of equilibria, the properties along dynamic paths and the underlying policy regime. Binding

multiple reserve requirements may help in reducing the scope for financial fragility and panic equilibria, but

backing of the domestic money supply has stabilizing effects only under fixed exchange rates.

The remainder of the paper proceeds as follows. In Sections 2 and 3, we analyze the properties of

stationary and dynamic equilibria under the alternative exchange rate regimes where no crises are possible in

equilibrium. In Section 4, we allow for the possibility of crises by introducing extrinsic and intrinsic

uncertainties. Section 5 concludes.

2. Floating Exchange Rates: the Case of Indonesia, Korea, Philippines and Thailand

In this section, we build the model of a SOE that captures the main stylized characteristics shared by the

Indonesian, Korean, Filipino and Thai economies at the time of the crisis. Here, we focus on the construction

of the general equilibrium and, thus, we do not allow for any event that could lead to a crisis of any type. The

reader interested can find the analysis of crises in Section 4.

The (private) banking sector is a net debtor with respect to the rest of the world, and there is an

exogenous and binding upper limit to foreign credit faced by domestic banks at each point in time, so that

credit is always rationed. We will observe ex-ante identical domestic agents who face uncertainty as to their

preferences types. The distribution of this shock is public information, but its realization is known only by the

private agents. Our model has the potential for strategic complementarities, taking the form of a standard

problem in coordination that may lead to crises of a self-fulfilling type8. We will see that two fiat national

currencies can potentially circulate simultaneously: a domestic fiat currency and a foreign fiat currency. The

legal regulations in financial intermediation and foreign exchange establish the following: 1) All intermediated

domestic investment is subject to multiple, unremunerated and binding reserve requirements. 2) A flexible

exchange rate regime is in place, and thus the nominal exchange rate will be market-determined; and 3) There

are no legal domestic restrictions on either using foreign currency or on obtaining foreign credit.

2.1 The Environment

Consider a pure exchange, SOE consisting of an infinite sequence of two-date-lived, overlapping generations.

Time is discrete, and indexed by

1,2,3.

t 

Standard analysis of an overlapping-generations economy

typically groups households into two categories: all the future generations versus the generation of initial old.

Moreover, we will observe four groups of players in this model economy: households, domestic banks, foreign

8 The decisions made by individual agents will be intertwined with the choices of other agents, giving rise to strategic

interdependence between an agent’s actions and the actions of others.

Page 5

banks and the domestic monetary authority. Foreign banks will lend to domestic banks inelastically at the

world interest rates and up to the exogenous binding limit. The monetary authority in this model economy is in

charge of choosing the combination of monetary policies consistent with floating exchange rates.

Each of the future generations, on the one hand, consists of a continuum of households with unit mass.

A household born at date t is young at date t and old at date

t . Households within a generation are ex

ante identical, but they can become of one of the following types before the end of their youth: impatient, with