Answer to Question #260365 in Macroeconomics for Kavita

Question

researcher wants to estimate the reserve demand equation i.e. growth rate of Forex reserves (percentage change in total reserves minus gold) held by the central bank of country A as function of growth rate of exchange rate (percentage change in exchange rate) and interest rate differential (difference in money market interest rate of Country A and the Fed Funds Rate) using monthly data from January 1994 to July 2021. Assuming that the researcher has found 3 breaks based on multiple breakpoint test. Formulate an econometric model to account for these breaks (you may decide to use your own break dates) using relevant variables and interpret the coefficient of this model.

Answer 1

Researchers have produced a broad range of estimations of the demand of banking systems for reserve balances post crisis. The estimates have a common feature- a level of reserve demand significantly above pre- crisis levels and below holdings over the last decade. The estimation of the lowest level of reserves needed by the banking system is challenging. This is because the banks currently hold reserves that are in excess of their operating needs and historical demand for reserves may not provide an accurate guide in post- crisis environment.

The econometric model employed in this case is the introduction of a range of estimates of the banking system's contemporary demand for reserves based on confidential microdata from a senior financial officer survey, conducted by the federal reserve.

This survey asks senior financial officers from each respondent bank for the approximate lowest level of reserves their institution would feel uncomfortable holding before taking action of maintaining or increasing their reserve balance levels. Extrapolations from survey results help to arrive at a range of estimates of the lowest comfortable level of reserves for the whole banking system.