International Reserves and Central Bank Independence

This paper proposes a novel theory of reserve accumulation that emphasizes the role of anindependent central bank. Motivated by a positive correlation between reserve accumulation and central bankindependence in Latin America, the paper develops a quantitative sovereign default model with an independentcentral bank that can accumulate a risk-free foreign asset. The findings show that if the central bank is more patientthan the government and as patient as households are, in equilibrium, the government issues more debt than what issocially optimal, and the central bank accumulates reserves to undo government over-borrowing. A key insight is that thegovernment can issue more debt for any level of reserves but chooses not to because doing so would increase sovereignspreads, making it more costly to borrow. Quantitatively, the analysis finds that the central bank independencechannel accounts for 75 percent of the average reserve levels observed in Mexico from 1994 to 2017. Finally, thepaper shows that accumulating reserves improves social welfare. Welfare gains come from reducing the costs offront-loading public spending.