Reserve Accumulation, Inflation and Moral Hazard: Evidence from a Natural Experiment

45 Pages Posted: 9 Feb 2016

See all articles by Livia Chitu

Livia Chitu

European Central Bank (ECB)

Date Written: February 8, 2016

Abstract

This paper assesses whether international reserve accumulation can be inflationary because of moral hazard and incentive effects. It tests the hypothesis that an increase in international reserves may incentivise countries to become complacent and pursue less prudent policies due to the perceived safety provided by higher reserve holdings. The paper uses a unique natural experiment to solve the endogeneity problem between reserve accumulation and macroeconomic developments, namely the 2009 general allocation of Special Drawing Rights (SDR). This allocation – the first one in almost three decades – enables to cleanly trace the effect of an unanticipated, global exogenous shock to the reserve holdings of the 186 IMF member countries. Difference-in-differences and propensity score matching estimates suggest that inflation in countries receiving large SDR allocations was about half a percentage point higher in annual terms within the next two years following the allocation, controlling for the standard arguments of the Phillips curve and other determinants. This effect is commensurate to the size of discretionary fiscal deficits in these countries, which is also consistent with the hypothesis that reserve accumulation may be inflationary because of moral hazard and incentive effects.

Keywords: international reserves, moral hazard, special drawing right, natural experiment, difference-in-differences, propensity score matching estimates

JEL Classification: F30

Suggested Citation

Chitu, Livia, Reserve Accumulation, Inflation and Moral Hazard: Evidence from a Natural Experiment (February 8, 2016). ECB Working Paper No. 1880. Available at SSRN: https://ssrn.com/abstract=2729169

Livia Chitu (Contact Author)

European Central Bank (ECB) ( email )

Sonnemannstrasse 22
Frankfurt am Main, 60314
Germany

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