On the use of reserve requirements in dealing with capital flow problems

In recent years, many developing countries have intervened in foreign exchange markets to offset to some extent the effect on their economies of large capital flows. Often changes in reserve requirements were used to mitigate the impact of that intervention on domestic money supplies. Because reserve requirements are a tax, however, changes in reserve requirements can have real effects. This paper shows that the exact implications for output, the real exchange rate and the capital and current accounts depend importantly on who-whether depositors or borrowers-pays the tax. In any case, foreign exchange intervention matched by changes in reserve requirements that keep the money supply fixed do influence the exchange rate in the short and, sometimes, the long run. The recent experiences of ten developing countries establish that, while the incidence of the tax varies considerably across countries and time, both deposit and lending rates of interest respond to changes in reserve requirements. (C) 1999 John Wiley & Sons, Ltd.