A Macroprudential Theory of Foreign Reserve Accumulation
This paper proposes a theory of foreign reserves as macroprudential policy. We study an open economy model of financial crises, in which pecuniary externalities lead to overborrowing, and show that by accumulating international reserves, the government can achieve the constrained-efficient allocation. The optimal reserve accumulation policy leans against the wind and significantly reduces the exposure to financial crises. The theory is consistent with the joint dynamics of private and official capital flows, both over time and in the cross section, and can quantitatively account for the recent upward trend in international reserves.
For useful comments and suggestions, we thank Manuel Amador, Tim Kehoe, Anna Lipinska, and Nicolas Magud, as well as conference/seminar participants at the 2019 BIS-BoE-ECB-IMF Basel Workshop, the 2019 Midwest Macro Meetings, 2019 SED, and the University of Minnesota Trade Workshop. The views expressed herein are those of the authors and not necessarily those of the Bank of Canada, the Federal Reserve Bank of Minneapolis, the Federal Reserve System, or the National Bureau of Economic Research.