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Sudden Stops, Productivity and the Optimal Level of International Reserves for Small Open Economies

Author

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  • Alexander Mihailov

    (University of Reading)

  • Harun Nasir

    (Zonguldak Bülent Ecevit University, Incivez)

Abstract

This paper contributes to the theory of optimal international reserves by extending the Jeanne-Rancière (Econ J 121:905-930, 2011) endowment small open economy (SOE) model to a SOE with production that accounts for the main sources of economic growth. We, first, derive a richer analytical version of the optimal reserves formula in our set-up, essentially driven by labour-augmenting productivity and the saving rate. Then, under a plausible calibration based on 1975-2020 data averages for typical emerging market countries facing the risk of sudden stops in capital inflows, we find that the optimal reserves-to-output ratio is 7.5%, i.e., the mid-point in the range between that in Jeanne and Rancière (Econ J 121:905-930, 2011), of 9.1%, calibrated to the same sample of 34 middle-income countries, and that in Bianchi et al. (Am Econ Rev 108(9):2629-2670, 2018), of 6.0%, obtained in a different, sovereign debt model without capital and production. We explain the lower optimal reserves-to-output ratio relative to the endowment SOE by the role of capital accumulation as precautionary saving: the accumulated capital stock can potentially be used as a pledge to external creditors in obtaining borrowing, thereby insuring better a SOE against sudden stops. As the countries in our sample appear quite heterogeneous, we also compute the optimal reserves-to-output ratio by region. It turns out that our extended to production insurance SOE model matches well the average reserves-to-output ratio in the data for Latin America, represented by nearly half of our sample, 16 countries, at just above 10%. Yet, for Asia, Africa and Europe our regional model-based ratios understate considerably the respective data averages, suggesting the need to explore alternative modelling approaches.

Suggested Citation

  • Alexander Mihailov & Harun Nasir, 2022. "Sudden Stops, Productivity and the Optimal Level of International Reserves for Small Open Economies," Open Economies Review, Springer, vol. 33(5), pages 825-851, November.
  • Handle: RePEc:kap:openec:v:33:y:2022:i:5:d:10.1007_s11079-022-09678-2
    DOI: 10.1007/s11079-022-09678-2
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    1. Alexander Mihailov & Harun Nasir, 2022. "Sudden Stops, Productivity and the Optimal Level of International Reserves for Small Open Economies," Open Economies Review, Springer, vol. 33(5), pages 825-851, November.

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    More about this item

    Keywords

    Optimal international reserves; Small open economies; Sudden stops; Production technology; Precautionary saving; Insurance contracts;
    All these keywords.

    JEL classification:

    • E21 - Macroeconomics and Monetary Economics - - Consumption, Saving, Production, Employment, and Investment - - - Consumption; Saving; Wealth
    • E23 - Macroeconomics and Monetary Economics - - Consumption, Saving, Production, Employment, and Investment - - - Production
    • F32 - International Economics - - International Finance - - - Current Account Adjustment; Short-term Capital Movements
    • F34 - International Economics - - International Finance - - - International Lending and Debt Problems
    • F41 - International Economics - - Macroeconomic Aspects of International Trade and Finance - - - Open Economy Macroeconomics
    • O40 - Economic Development, Innovation, Technological Change, and Growth - - Economic Growth and Aggregate Productivity - - - General

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