Working Paper: NBER ID: w27923
Authors: Luis Felipe Cespedes; Roberto Chang
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.
Keywords: foreign reserves; central bank policy; financial stress; liquidity provision
JEL Codes: E5; F3; F4
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| binding financial constraints (G21) | rise in domestic interest rates (E43) |
| rise in domestic interest rates (E43) | inefficiently low investment and consumption (E20) |
| central bank's accumulation of reserves (E58) | liquidity provision (E41) |
| central bank's liquidity provision (E58) | alleviate inefficiencies in investment (D61) |
| central bank's reserve accumulation (E58) | improve welfare (I30) |
| optimal level of reserves (E63) | depends on term premium, financial uncertainty, and nature of intervention (E43) |
| central bank's reserve accumulation (E58) | influence private sector behavior (L33) |
| influence private sector behavior (L33) | increased borrowing (H74) |
| central bank's reserve accumulation (E58) | overall stability of the financial system (E44) |
| sufficient reserves accumulation (E22) | eliminate crises (H12) |
| optimal reserves (Q31) | depend on economy's fundamentals and liquidity policy specifics (E60) |