Toward a “New” Inflation-Targeting Framework: The Case of Uruguay
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Toward a “New” Inflation-Targeting Framework:
The Case of Uruguay

Empirical studies in the late 1980s, suggesting that monetary policy might influence the short-run dynamics of the real economy, contributed to the widespread use of inflation-targeting policy rules by central banks. More recent research on monetary economics provide a theoretical framework for the implementation of such rules. For example, Taylor (1993) recommends the use of a simple interest rate rule that is a function of inflation and the output gap. Nowadays it is standard to use the dynamic stochastic general equilibrium (DSGE) model and New Keynesian models to evaluate the effects of Federal Reserve policies. The success of alternative policy rules is usually assessed in terms of the short-run dynamics of the relevant macroeconomic variables.

Many central banks use the reference interest rate as a conventional instrument to signal to the public changes in the monetary policy stance. In this way they attempt to achieve the convergence of inflation, and its expectation, upon a given target. Recently several central banks in Latin American countries (LAC) adopted stabilization policies using conventional and unconventional tools to meet their inflationary or financial stability objectives. Among the unconventional tools are reserve requirements (see Glocker and Towbin, 2012, and the references there for several emerging countries outside Latin America; for LACs, see Carvalho and Acevedo, 2008; Ocampo and Tovar, 2003; Ribeira and Barbosa, 2005; [End Page 89] Vargas and others, 2010). In highly dollarized LAC, changes in reserve requirements have been used as a macroeconomic prudential tool, with the main objective of accumulating liquidity being to address financial stress (see León and Quispe, 2010; Vargas and Cardozo, 2012; Tovar, Garcia-Escribano, and Vera Martin, 2012; Carrera and Vega, 2012) and to complement the use of the reference interest rate in order to achieve the inflation target objective (see Comunicados del COPOM, 2007–12, for Uruguay; Glocker and Towbin, 2012). However, most of the literature on the use of reserve requirements in LAC is not only empirical but is mostly focused on the impact of these requirements on interest spreads and bank profits. The main conclusion from those studies is that an increase in reserve requirements induces an increment in interest rate spreads and a fall in bank profits. An increment in reserve requirements acts as a tax on the banks and widens the spread between lending and deposit rates (see Glocker and Towbin, 2012).

Monetary policy shocks typically generate a short-run fall in inflation through a contractionary effect on economic activity. Furthermore, in highly dollarized economies, these shocks may also have undesirable effects on the foreign exchange market (Montoro and Moreno, 2011). Therefore, the use of reserve requirements may be an important unconventional monetary policy tool, since it could help to achieve the inflationary target without having major effects on the exchange rate market (that is, without attracting capital inflows), and it may also reduce the negative impact of the increase in interest rates on output.

Nevertheless, the short-run effects of this type of policy are not obvious, since it depends on, among other things, the combination of instruments chosen to achieve the target and the type of target under consideration. The main objective of this paper is to describe the impact of using conventional and unconventional tools to meet inflationary or financial stability objectives in a dollarized economy. This paper explores, for the Uruguayan economy, the impact of these policies, using a relatively standard model of a small open economy with sticky prices, financial frictions, and a banking sector that is subject to legal reserve requirements.1

The three main findings of the paper are as follows. One, reserve requirements can be used to achieve the inflationary objectives of the central bank. [End Page 90] However, reducing inflation using this instrument also produces a real appreciation of the Uruguayan peso. Two, when the central bank uses the monetary policy rate as an instrument, the effect of the reserve requirements is to reduce the negative impact on consumption, investment, and output of an eventual increase in the interest rate. Nevertheless, the quantitative results in terms...