International Reserve Holdings with Sovereign Risk and Costly Tax Collection

33 Pages Posted: 5 Sep 2002 Last revised: 28 Oct 2010

See all articles by Joshua Aizenman

Joshua Aizenman

National Bureau of Economic Research (NBER)

Nancy Peregrim Marion

Dartmouth College - Department of Economics

Multiple version iconThere are 4 versions of this paper

Date Written: September 2002

Abstract

This paper analyzes the international reserve-holding behavior of developing countries. It shows that political-economy considerations modify the optimal reserve level determined by efficiency criteria. A country characterized by volatile output, inelastic demand for fiscal outlays, high tax collection costs and sovereign risk will want to accumulate international reserves as well as external debt. Efficiency considerations imply that reserves are optimal when the benefits they provide for intertemporal consumption and distortion smoothing equal the costs of acquiring them. However, a greater chance of opportunistic behavior by future policy makers reduces the demand for international reserves and increases external borrowing. Political corruption also reduces optimal reserve holdings. We provide some evidence to support these findings. Consequently, the debt-to-reserves ratio may be less useful as a vulnerability indicator. A version of the Lucas Critique suggests that if a high debt-to-reserves ratio is a symptom of opportunistic behavior, a policy recommendation to increase international reserve holdings may be welfare-reducing.

Suggested Citation

Aizenman, Joshua and Marion, Nancy P., International Reserve Holdings with Sovereign Risk and Costly Tax Collection (September 2002). NBER Working Paper No. w9154, Available at SSRN: https://ssrn.com/abstract=328700

Joshua Aizenman (Contact Author)

National Bureau of Economic Research (NBER) ( email )

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

Nancy P. Marion

Dartmouth College - Department of Economics ( email )

Hanover, NH 03755
United States
(603) 646-2511 (Phone)

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