On the Effectiveness of Foreign Exchange Reserves During the 2021-22 U.S. Monetary Tightening Cycle

Abstract

This paper examines whether levels of foreign exchange (FX) reserves and other fundamental factors explain cross-country differences in foreign currency depreciation observed over the 2021-22 Federal Reserve monetary policy tightening that led to a sharp appreciation of the US dollar. Considering a broad cross-section of countries, we document that an additional 10 percentage points of FX reserves/GDP held ex-ante were associated with 1.5 to 2 percent less exchange rate depreciation and this buffer effect was larger among less financially developed economies. Higher ex-ante policy rates were also associated with less depreciation, especially among financially open economies. Taken together, these results support the buffering role of FX reserves and their potential to promote monetary policy independence in the presence of international spillovers.

Keywords: International Reserves, Trilemma, Global Financial Cycle, Currency Risk, Spillovers

JEL Classification: F3, F31, F32, F36