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The Optimal Level of Foreign Reserves in Financially Dollarized Economies

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  • Fernando M. Gonçalves

Abstract

This paper extends the framework derived by Jeanne and Rancière (2006) by explicitly incorporating the dollarization of bank deposits into the analysis of the optimal level of foreign reserves for prudential purposes. In the extended model, a sudden stop in capital flows occurs in tandem with a run on dollar deposits. Reserves can smooth consumption in a crisis but are costly to carry. The resulting expression for the optimal level of reserves is calibrated for Uruguay, a country with high dollarization of bank deposits. The baseline calibration indicates that the gap between actual and optimal reserves has declined sharply since the 2002 crisis due to a substantial reduction in vulnerabilities. While the results suggest that reserves are now near optimal levels, further accumulation may be desirable going forward, partly because banks'' currently high liquidity levels are likely to decline as the credit recovery matures.

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Bibliographic Info

Paper provided by International Monetary Fund in its series IMF Working Papers with number 07/265.

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Length: 24
Date of creation: 01 Nov 2007
Date of revision:
Handle: RePEc:imf:imfwpa:07/265

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Keywords: Foreign exchange reserves; central bank; banking; foreign currency debt; currency debt; reserve accumulation; reserve adequacy; external debt; bank reserves; banking sector; short-term debt; banking crisis; balance of payments; short term debt; bank deposits; banking crises; foreign exchange; domestic absorption; foreign debt; currency crisis; bank runs; long-term debt; central banks; international reserve; reserve holdings; monetary authority; banking regulations; public debt; public foreign currency debt; current account; banking system; bank run; banking regulation; external public debt; liquid asset; bank deposit; bank reserve; foreign exchange market; banks ? balance sheet; bank policy;

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References

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  1. Pablo García & Claudio Soto, 2004. "Large Hoardings of International Reserves: Are They Worth It?," Working Papers Central Bank of Chile 299, Central Bank of Chile.
  2. Michael Hutchison & Ilan Noy, 2002. "How bad are twins? output costs of currency and banking crises," Pacific Basin Working Paper Series 2002-02, Federal Reserve Bank of San Francisco.
  3. Eduardo Levy Yeyati, 2006. "Liquidity Insurance in a Financially Dollarized Economy," Business School Working Papers liquid, Universidad Torcuato Di Tella.
  4. Christian B. Mulder & Matthieu Bussière, 1999. "External Vulnerability in Emerging Market Economies," IMF Working Papers 99/88, International Monetary Fund.
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Cited by:
  1. Marta Ruiz-Arranz & Milan Zavadjil, 2008. "Are Emerging Asia’s Reserves Really too High?," IMF Working Papers 08/192, International Monetary Fund.
  2. Ana Maria Ceh & Ivo Krznar, 2008. "Optimal Foreign Reserves: The Case of Croatia," Financial Theory and Practice, Institute of Public Finance, vol. 32(4), pages 421-460.
  3. Wendell A. Samuel & Emilio Pineda & Mario Dehesa, 2009. "Optimal Reserves in the Eastern Caribbean Currency Union," IMF Working Papers 09/77, International Monetary Fund.

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