Foreign  Reserves as a Monetary Policy Buffer

Abstract

This paper examines how foreign exchange reserves asymmetrically affect monetary policy independence of peripheral economies in response to U.S. interest rate adjustments. During the periods of U.S. monetary policy tightening, usually accompanied by elevated currency crisis risk of peripheral economies, high‐reserve countries can deploy reserves to counter capital outflows, stabilize their currency, and maintain domestic monetary policy independence. Low‐reserve countries, however, have to raise the interest rates to defend their exchange rates, effectively transmitting U.S. rate hikes. However, during U.S. rate cuts, both high‐ and low‐reserve countries opt not to preserve monetary policy autonomy and instead, follow the easing cycle, consistent with “fear of appreciation”. Moreover, the asymmetric impact of reserves is magnified in countries with higher internal or external risks, weaker fundamentals, or poorer institutional quality.

Keywords: International monetary transmission, Trilemma, Foreign exchange reserves