Working Paper: NBER ID: w27323
Authors: Javier Bianchi; César Sosapadilla
Abstract: In the past three decades, governments in emerging markets have accumulated large amounts of international reserves, especially those with fixed exchange rates. This paper proposes a theory of reserve accumulation that can account for these facts. Using a model of endogenous sovereign default with nominal rigidities, we argue that the interaction between sovereign risk and aggregate demand amplification generates a macroeconomic-stabilization hedging role for international reserves. We show that issuing debt to purchase reserves during good times allows the government to stabilize aggregate demand when sovereign spreads rise and rolling over the debt becomes more expensive. We provide empirical evidence consistent with the model's predictions.
Keywords: international reserves; macroeconomic stabilization; sovereign risk; exchange rate regimes
JEL Codes: F32; F34; F41
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| interaction between sovereign risk and aggregate demand amplification (F41) | macroeconomic-stabilization hedging role for international reserves (E63) |
| accumulating reserves (E22) | stabilize aggregate demand during economic downturns (E00) |
| sovereign spreads rise (H63) | debt more expensive to roll over (H63) |
| issuing debt to purchase reserves during favorable economic conditions (E52) | mitigate severity of future recessions (E65) |
| countries with fixed exchange rates (F33) | hold more reserves (Q35) |
| common increase in risk premia (G19) | steeper upward trend in reserves for fixed exchange rate economies (F31) |