Bank Reserve's Setting for Minimizing the Price Fluctuations: Taiwan's Case Studies

Abstract

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 liquid asset market and high-powered money market. An important policy implication, drawn from my model, suggests that it may help for the stabilization of price level if a lower level of the reserve requirements was adopted by the central bank when the shock exists solely in liquid asset market. An application of the presented model to the financial assets in Taiwan suggests that the optimal reserves ratio for stabilizing price level is approximately 5.7717 per cent in the case of the 2-SLS estimation, and 4.2442 per cent in the case of the SUR estimation, below the weighted average of actual 7.7575 per cent 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.