Optimal Foreign Reserves and Central Bank Policy Under Financial Stress

44 Pages Posted: 14 Oct 2020

See all articles by Luis Felipe Céspedes

Luis Felipe Céspedes

affiliation not provided to SSRN

Roberto Chang

Rutgers University, New Brunswick/Piscataway - Faculty of Arts and Sciences-New Brunswick/Piscataway - Department of Economics; National Bureau of Economic Research (NBER)

Date Written: October 2020

Abstract

We study the interaction between optimal foreign reserves accumulation and central bank international liquidity provision in a small open economy under financial stress. Firms and households finance investment and consumption by borrowing from domestic financial intermediaries (banks), which in turn borrow from abroad. Binding financial constraints can cause the domestic rate of interest to rise above the world rate and the real exchange rate to depreciate, leading to inefficiently low investment and consumption. A role then emerges for a central bank that accumulates reserves in order to provide liquidity if financial frictions bind. The optimal level of international reserves in this context depends, among other variables, on the term premium, the depth of financial markets, ex ante financial uncertainty and the precise way the central bank intervenes. The model is consistent with both the increase in international reserves observed during the period 2004-2008 and with policy intervention after the Lehman bankruptcy.

Institutional subscribers to the NBER working paper series, and residents of developing countries may download this paper without additional charge at www.nber.org.

Suggested Citation

Céspedes, Luis Felipe and Chang, Roberto, Optimal Foreign Reserves and Central Bank Policy Under Financial Stress (October 2020). NBER Working Paper No. w27923, Available at SSRN: https://ssrn.com/abstract=3709613

Luis Felipe Céspedes (Contact Author)

affiliation not provided to SSRN

No Address Available

Roberto Chang

Rutgers University, New Brunswick/Piscataway - Faculty of Arts and Sciences-New Brunswick/Piscataway - Department of Economics ( email )

75 Hamilton Street
New Brunswick, NJ 08901
United States

National Bureau of Economic Research (NBER)

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

Do you have a job opening that you would like to promote on SSRN?

Paper statistics

Downloads
0
Abstract Views
68
PlumX Metrics