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Can High Reserves Offset Weak Fundamentals? A Simple Model of Precautionary Demand for Reserves

Author

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  • Jie Li

    () (Claremont Graduate University, California.)

  • Ramkishen Rajan

    () (School of Public Policy, National University of Singapore.)

Abstract

Apart from exchange rate objectives which have resulted in reserve accumulation as a side effect, Asian countries have chosen explicitly to build up reserves at least in part for precautionary motives. This paper explores the issue of optimal precautionary demand for reserves by a central bank within a context of a simple analytical model. The model suggests that, in general, high reserves can help offset moderately weak fundamentals. However, if fundamentals are sufficiently weak, no level of reserves will be able to counterbalance the weak fundamentals. This is broadly consistent with the escape clause based second-generation models of currency crisis.

Suggested Citation

  • Jie Li & Ramkishen Rajan, 2005. "Can High Reserves Offset Weak Fundamentals? A Simple Model of Precautionary Demand for Reserves," Centre for International Economic Studies Working Papers 2005-09, University of Adelaide, Centre for International Economic Studies.
  • Handle: RePEc:adl:cieswp:2005-09
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    File URL: http://www.adelaide.edu.au/cies/papers/0509.pdf
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    References listed on IDEAS

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    1. Jung Sik Kim & Jie Li & Ramkishen S. Rajan & Ozan Sula & Thomas D. Willett, 2007. "Reserve Adequacy In Asia Revisited: New Benchmarks Based On The Size And Composition Of Capital Flow," Korean Economic Review, Korean Economic Association, pages 131-158.
    2. M. Nowak & Ketil Hviding & Luca A Ricci, 2004. "Can Higher Reserves Help Reduce Exchange Rate Volatility?," IMF Working Papers 04/189, International Monetary Fund.
    3. Ben-Bassat, Avraham & Gottlieb, Daniel, 1992. "Optimal international reserves and sovereign risk," Journal of International Economics, Elsevier, pages 345-362.
    4. Christian B. Mulder & Matthieu Bussière, 1999. "External Vulnerability in Emerging Market Economies; How High Liquidity Can Offset Weak Fundamentals and the Effects of Contagion," IMF Working Papers 99/88, International Monetary Fund.
    5. Kletzer, Kenneth & Spiegel, Mark M., 2004. "Sterilization costs and exchange rate targeting," Journal of International Money and Finance, Elsevier, vol. 23(6), pages 897-915, October.
    Full references (including those not matched with items on IDEAS)

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    Cited by:

    1. Xingwang Qian & Andreas Steiner, 2014. "International Reserves and the Composition of Foreign Equity Investment," Review of International Economics, Wiley Blackwell, pages 379-409.
    2. Martín Redrado & Jorge Carrera & Diego Bastourre & Javier Ibarlucia, 2006. "The Economic Policy of Foreign Reserve Accumulation: New International Evidence," BCRA Working Paper Series 200614, Central Bank of Argentina, Economic Research Department.
    3. Martín Redrado & Jorge Carrera & Diego Bastourre & Javier Ibarlucia (ed.), 2006. "The Economic Policy of Foreign Reserve Accumulation: New International Evidence," BCRA Paper Series, Central Bank of Argentina, Economic Research Department, number 02.
    4. Jie Li & Alice Ouyang, 2011. "Currency crises: can high reserves offset vulnerable fundamentals?," Applied Economics, Taylor & Francis Journals, vol. 43(16), pages 2055-2069.
    5. Cavoli, Tony & Rajan, Ramkishen S., 2009. "Managing Risks in a Volatile Environment: The Capital Inflows Problem in Asia," Economia Internazionale / International Economics, Camera di Commercio Industria Artigianato Agricoltura di Genova, vol. 62(3), pages 325-340.
    6. Mendoza, Ronald U., 2010. "Was the Asian crisis a wake-up call?: Foreign reserves as self-protection," Journal of Asian Economics, Elsevier, pages 1-19.

    More about this item

    Keywords

    crisis management; crisis prevention; currency crisis; precautionary motive; reserves.;

    JEL classification:

    • F15 - International Economics - - Trade - - - Economic Integration
    • F31 - International Economics - - International Finance - - - Foreign Exchange
    • F43 - International Economics - - Macroeconomic Aspects of International Trade and Finance - - - Economic Growth of Open Economies

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