Costly State Monitoring and Reserve Requirements

Rangan Gupta

The paper explores one rationale behind the existence of financial repression, with the latter being represented through the obligatory ``high" reserve requirement for the banks. Using an overlapping generations production-economy-monetary model characterized by possibility of banking crisis, we try and answer, whether sizes of reserve requirements are related to probability of crisis. Results indicate that economies with higher probability of banking crisis should optimally choose higher income taxation. The correlation between optimal reserve requirements and probability of crisis is positive only when the social planner has exhausted his ability of income taxation.