Optimal Foreign Reserves and Central Bank Policy Under Financial Stress

Luis Cespedes and Roberto Chang

No 27923, NBER Working Papers from National Bureau of Economic Research, Inc

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.

JEL-codes: E5 F3 F4 (search for similar items in EconPapers)
Date: 2020-10
New Economics Papers: this item is included in nep-cba, nep-ifn, nep-mac, nep-mon and nep-opm
Note: IFM
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Citations: View citations in EconPapers (5)

Published as Luis Felipe Céspedes & Roberto Chang, 2024. "Optimal Foreign Reserves and Central Bank Policy under Financial Stress," American Economic Journal: Macroeconomics, vol 16(3), pages 230-267.

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