The Macroeconomic Effects of Macroprudential Policy: Evidence from a Narrative Approach

We analyze the macroeconomic effects of macroprudential policy – in the form of legal reserve requirements – in three Latin American countries (Argentina, Brazil, and Uruguay). To correctly identify innovations in changes in legal reserve requirements, we develop a narrative approach – based on contemporaneous reports from the IMF and Central Banks in the spirit of Romer and Romer (2010) – that classifies each change into endogenous or exogenous to the business cycle. We show that this distinction is critical in understanding the macroeconomic effects of reserve requirements. In particular, we show that output falls in response to exogenous increases in legal reserve requirements but would seem not to be affected (or could even increase!) when using all changes and relying on traditional time-identifying strategies. This bias reflects the practical relevance of the misidentification of endogenous countercyclical changes in reserve requirements. We also push the empirical frontier along two important dimensions. First, in measuring legal reserve requirements, we take into account both the different types of legal reserve requirements in terms of maturity and currency of denomination as well as the structure of deposits. Second, since in practice reserve requirement policy is tightly linked to monetary policy, we also jointly analyze the macroeconomic effects of changes in central bank interest rates. To properly identify exogenous central bank interest rate shocks, we follow Romer and Romer (2004).