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International reserves for emerging economies: A liquidity approach

Listed author(s):
  • Jung, Kuk Mo
  • Pyun, Ju Hyun

The massive stocks of foreign exchange reserves, mostly held in the form of U.S. T-bonds by emerging economies, are still an important puzzle. Why do emerging economies continue to willingly loan to the United States despite the low rates of return? We suggest that a dynamic general equilibrium model incorporating international capital markets, characterized by decentralized trade and U.S. T-bonds as facilitators of trade, can provide one possible resolution to this question. Declining financial frictions in these over-the-counter (OTC) markets would generate rising liquidity premium on U.S. T-bonds, thereby causing low U.S. real interest rates. Meanwhile, the superior liquidity properties of the U.S. T-bonds would induce recipients of foreign investments, namely emerging economies, to hold more liquidity, that is U.S. T-bonds, in equilibrium. The prediction of our model is confirmed by an empirical simultaneous equations approach considering an endogenous relationship between OTC capital inflows and reserve holdings.

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File URL: http://www.sciencedirect.com/science/article/pii/S0261560616300663
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Article provided by Elsevier in its journal Journal of International Money and Finance.

Volume (Year): 68 (2016)
Issue (Month): C ()
Pages: 230-257

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Handle: RePEc:eee:jimfin:v:68:y:2016:i:c:p:230-257
DOI: 10.1016/j.jimonfin.2016.06.020
Contact details of provider: Web page: http://www.elsevier.com/locate/inca/30443

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