Working Paper: CEPR ID: DP9224
Authors: Gianluca Benigno; Luca Fornaro
Abstract: We present a model that reproduces two salient facts characterizing the international monetary system: i) Faster growing countries are associated with lower net capital inflows and ii) Countries that grow faster accumulate more international reserves and receive more net private inflows. We study a two-sector, tradable and non-tradable, small open economy. There is a growth externality in the tradable sector and agents have imperfect access to international financial markets. By accumulating foreign reserves, the government induces a real exchange rate depreciation and a reallocation of production towards the tradable sector that boosts growth. Financial frictions generate imperfect substitutability between private and public debt flows so that private agents do not perfectly offset the government policy. This generates a positive link between reserve accumulation, growth and current account surpluses. The possibility of using reserves to provide liquidity during crises amplifies the positive impact of reserve accumulation on growth. We use the model to compare the laissez-faire equilibrium and the optimal reserve policy in an economy that is opening to international capital flows. We find that the optimal reserve management entails a fast rate of reserve accumulation, as well as higher growth and larger current account surpluses compared to the economy with no policy intervention. We also find that the welfare gains of reserve policy are large, in the order of 1% of permanent consumption equivalent.
Keywords: financial crises; foreign reserve accumulation; gross capital flows; growth
JEL Codes: F31; F32; F41; F43
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| reserve accumulation (E21) | real exchange rate depreciation (F31) |
| real exchange rate depreciation (F31) | production reallocation towards tradable sector (F16) |
| production reallocation towards tradable sector (F16) | growth (O40) |
| reserve accumulation (E21) | growth (O40) |
| growth (O40) | lower net capital inflows (F21) |
| faster growth (O49) | higher international reserves (F30) |
| faster growth (O49) | higher net private inflows (F21) |
| reserve accumulation (E21) | liquidity during crises (G01) |
| liquidity during crises (G01) | long-run growth (O49) |