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Balance sheet effects, foreign reserves and public policies

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  • Cheng, Gong

Abstract

This paper shows that countries can use foreign reserves to enhance their domestic economies' resilience to potential risks from balance sheet effects. Based on a theoretical model, this paper demonstrates that the government can either deploy its foreign reserves to lend in foreign currency to the private sector or increase fiscal spending on domestic goods. Both these policy tools can remedy the bad equilibrium characterized by large-scale domestic currency depreciation and very low aggregate investment, but they diverge in how they stabilize the domestic economy and require different minimum amounts of foreign reserves. Targeted lending works by altering investors' expectations of the domestic exchange rate and of firms' net worth. As long as foreign reserves are sufficient to cover the private sector's external debt, this approach eliminates the bad equilibrium without an actual depletion of reserves. In contrast, fiscal spending increases the demand for domestic goods and affects the relative price, leading to domestic exchange rate appreciation that subsequently increases firms' net worth and facilitates investment.

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  • Cheng, Gong, 2015. "Balance sheet effects, foreign reserves and public policies," Journal of International Money and Finance, Elsevier, vol. 59(C), pages 146-165.
  • Handle: RePEc:eee:jimfin:v:59:y:2015:i:c:p:146-165
    DOI: 10.1016/j.jimonfin.2015.08.005
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    3. Collins C. Ngwakwe, 2017. "Analysis of the Role of Export Value on the Reserve of South Africa," Acta Universitatis Danubius. OEconomica, Danubius University of Galati, issue 13(4), pages 5-14, AUGUST.
    4. Hory, Marie-Pierre & Levieuge, Grégory & Onori, Daria, 2021. "Public spending, currency mismatch and financial frictions," Journal of International Money and Finance, Elsevier, vol. 116(C).
    5. Marie-Pierre HORY & Grégory LEVIEUGE & Daria ONORI, 2021. "Public spending, currency mismatch and financial frictions," LEO Working Papers / DR LEO 2873, Orleans Economics Laboratory / Laboratoire d'Economie d'Orleans (LEO), University of Orleans.
    6. Bussière, Matthieu & Cheng, Gong & Chinn, Menzie D. & Lisack, Noëmie, 2015. "For a few dollars more: Reserves and growth in times of crises," Journal of International Money and Finance, Elsevier, vol. 52(C), pages 127-145.
    7. Hory Marie Pierre, & Levieuge Grégory, & Onori Daria., 2021. "Public spending, currency mismatch and financial frictions," Working papers 813, Banque de France.

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    More about this item

    Keywords

    Foreign reserves; Currency mismatch; Balance sheet effects;
    All these keywords.

    JEL classification:

    • F31 - International Economics - - International Finance - - - Foreign Exchange
    • F32 - International Economics - - International Finance - - - Current Account Adjustment; Short-term Capital Movements
    • F41 - International Economics - - Macroeconomic Aspects of International Trade and Finance - - - Open Economy Macroeconomics
    • G01 - Financial Economics - - General - - - Financial Crises

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