Working Paper: NBER ID: w9154
Authors: Joshua Aizenman; Nancy Marion
Abstract: This paper analyzes the international reserve-holding behavior of developing countries. It shows that political-economy considerations modify the optimal reserve level determined by efficiency criteria. A country characterized by volatile output, inelastic demand for fiscal outlays, high tax collection costs and sovereign risk will want to accumulate international reserves as well as external debt. Efficiency considerations imply that reserves are optimal when the benefits they provide for intertemporal consumption and distortion smoothing equal the costs of acquiring them. However, a greater chance of opportunistic behavior by future policy makers reduces the demand for international reserves and increases external borrowing. Political corruption also reduces optimal reserve holdings. We provide some evidence to support these findings. Consequently, the debt-to-reserves ratio may be less useful as a vulnerability indicator. A version of the Lucas Critique suggests that if a high debt-to-reserves ratio is a symptom of opportunistic behavior, a policy recommendation to increase international reserve holdings may be welfare-reducing.
Keywords: No keywords provided
JEL Codes: F15; F32; F34
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| political instability (O17) | lower optimal reserve holdings (E52) |
| political corruption (D73) | lower optimal reserve holdings (E52) |
| high sovereign risk (F34) | lower optimal reserve holdings (E52) |
| political instability (O17) | reduced desired current reserve holdings (E41) |
| political corruption (D73) | reduced desired current reserve holdings (E41) |
| political instability (O17) | tax on effective return on reserves (H26) |
| political corruption (D73) | tax on effective return on reserves (H26) |
| high debt-to-reserves ratio (F34) | indicate political instability or corruption (D73) |
| increased political uncertainty (D89) | lower demand for reserves (E41) |
| increased political uncertainty (D89) | raise external borrowing (F34) |