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

  • Jie Li


    (Claremont Graduate University, California.)

  • Ramkishen Rajan


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

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.

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Paper provided by University of Adelaide, Centre for International Economic Studies in its series Centre for International Economic Studies Working Papers with number 2005-09.

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Length: 21 pages
Date of creation: Jun 2005
Date of revision:
Handle: RePEc:adl:cieswp:2005-09
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  1. M. Nowak & Ketil Hviding & Luca Antonio Ricci, 2004. "Can Higher Reserves Help Reduce Exchange Rate Volatility?," IMF Working Papers 04/189, International Monetary Fund.
  2. Kenneth Kletzer & Mark Spiegel, 1999. "Sterilization costs and exchange rate targeting," Pacific Basin Working Paper Series 99-03, Federal Reserve Bank of San Francisco.
  3. Ben-Bassat, Avraham & Gottlieb, Daniel, 1992. "Optimal international reserves and sovereign risk," Journal of International Economics, Elsevier, vol. 33(3-4), pages 345-362, November.
  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.
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