International Reserves: Precautionary Versus Mercantilist Views, Theory and Evidence

UC Santa Cruz International Economics Working Paper No. 05-11; UC Santa Cruz Economics Working Paper No. 600

27 Pages Posted: 24 May 2005

See all articles by Joshua Aizenman

Joshua Aizenman

National Bureau of Economic Research (NBER)

Jaewoo Lee

International Monetary Fund (IMF) - Research Department

Multiple version iconThere are 2 versions of this paper

Date Written: May 2005

Abstract

This paper tests the importance of precautionary and mercantilist motives in accounting for the hoarding of international reserves by developing countries, and provides a model that quantifies the welfare gains from optimal management of international reserves. While the variables associated with the mercantilist motive are statistically significant, their economic importance in accounting for reserve hoarding is close to zero and is dwarfed by other variables. Overall, the empirical results are in line with the precautionary demand. The effects of financial crises have been localized, increasing reserve hoarding in the aftermath of crises mostly in countries located in the affected region, but not in other regions. We also investigate the micro foundation of precautionary demand, extending Diamond and Dybvig (1983)'s model to an open, emerging market economy where banks finance long-term projects with short-term deposits. We identify circumstances that lead to large precautionary demand for international reserves, providing self-insurance against the adverse output effects of sudden stop and capital flight shocks. This would be the case if premature liquidation of long-term projects is costly, and the economy is de-facto integrated with the global financial system, hence sudden stops and capital flight may reduce deposits sharply. We show that the welfare gain from the optimal management of international reserves is of a first-order magnitude, reducing the welfare cost of liquidity shocks from a first-order to a second-order magnitude.

Keywords: International reserves, precautionary demand, mercantilist, financial crises

JEL Classification: F15, F31, F43

Suggested Citation

Aizenman, Joshua and Lee, Jaewoo, International Reserves: Precautionary Versus Mercantilist Views, Theory and Evidence (May 2005). UC Santa Cruz International Economics Working Paper No. 05-11; UC Santa Cruz Economics Working Paper No. 600. Available at SSRN: https://ssrn.com/abstract=727864 or http://dx.doi.org/10.2139/ssrn.727864

Joshua Aizenman (Contact Author)

National Bureau of Economic Research (NBER) ( email )

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

Jaewoo Lee

International Monetary Fund (IMF) - Research Department ( email )

700 19th Street NW
Washington, DC 20431
United States
202-623-7331 (Phone)
202-623-6334 (Fax)

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