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Why there is a lower bound on the central bank's foreign reserves


  • Alpo Willman

    (Bank of Finland)


This article examines the implications for the balance of payments of imposing a cash-in-advance constraint on financal market transactions. I show that with a welfare-maximizing government this constraint introduces a lower bound on the central bank's net foreign reserves; the depletion of the net foreign reserves below zero results in a welfare loss. I further show that either the private or public sector solvency constraint is violated, if the growth rate ofdomestic credit expansion exceeds a critical magnitude, which is somewhat below the foreign interest rate. Unlike in Buiter (198?), the violation of the solvency constraint does not depend on the way the credit expansion is used. The timing and the size of the speculative attack associated with an anticipated exchange rate regime shift are, however, dependent on the way the credit expansion is injected into the economy.

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  • Alpo Willman, 1991. "Why there is a lower bound on the central bank's foreign reserves," Finnish Economic Papers, Finnish Economic Association, vol. 4(2), pages 113-129, Autumn.
  • Handle: RePEc:fep:journl:v:4:y:1991:i:2:p:113-129

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    References listed on IDEAS

    1. Barro, Robert J. & Gordon, David B., 1983. "Rules, discretion and reputation in a model of monetary policy," Journal of Monetary Economics, Elsevier, vol. 12(1), pages 101-121.
    2. Stephen W. Salant & Dale W. Henderson, 1976. "Market anticipations, government policy, and the price of gold," International Finance Discussion Papers 81, Board of Governors of the Federal Reserve System (U.S.).
    3. Spaventa, Luigi, 1989. "Seigniorage: Old and new policy issues Introduction," European Economic Review, Elsevier, vol. 33(2-3), pages 557-563, March.
    4. Salant, Stephen W, 1983. "The Vulnerability of Price Stabilization Schemes to Speculative Attack," Journal of Political Economy, University of Chicago Press, vol. 91(1), pages 1-38, February.
    5. Salant, Stephen W & Henderson, Dale W, 1978. "Market Anticipations of Government Policies and the Price of Gold," Journal of Political Economy, University of Chicago Press, vol. 86(4), pages 627-648, August.
    6. Flood, Robert P. & Garber, Peter M., 1984. "Collapsing exchange-rate regimes : Some linear examples," Journal of International Economics, Elsevier, vol. 17(1-2), pages 1-13, August.
    7. Calvo, Guillermo A, 1987. "Balance of Payments Crises in a Cash-in-Advance Economy," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 19(1), pages 19-32, February.
    8. Vittorio Grilli & Nouriel Roubini, 1989. "Financial Integration, Liquidity and Exchange Rates," NBER Working Papers 3088, National Bureau of Economic Research, Inc.
    9. Willman, Alpo, 1987. "Speculative attacks on the currency with uncertain monetary policy reactions," Economics Letters, Elsevier, vol. 25(1), pages 75-78.
    10. Lucas, Robert Jr., 1990. "Liquidity and interest rates," Journal of Economic Theory, Elsevier, vol. 50(2), pages 237-264, April.
    11. Claessens, Stijn, 1988. "Balance-of-payments crises in a perfect foresight optimizing model," Journal of International Money and Finance, Elsevier, vol. 7(4), pages 363-372.
    12. Willman, Alpo, 1988. "The collapse of the fixed exchange rate regime with sticky wages and imperfect substitutability between domestic and foreign bonds," European Economic Review, Elsevier, vol. 32(9), pages 1817-1838, November.
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