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The Optimal Level of Foreign Reserves in Financially Dollarized Economies: The Case of Uruguay

  • Fernando M. Gonçalves

This paper extends the framework derived by Jeanne and Rancière (2006) by explicitly incorporating the dollarization of bank deposits into the analysis of the optimal level of foreign reserves for prudential purposes. In the extended model, a sudden stop in capital flows occurs in tandem with a run on dollar deposits. Reserves can smooth consumption in a crisis but are costly to carry. The resulting expression for the optimal level of reserves is calibrated for Uruguay, a country with high dollarization of bank deposits. The baseline calibration indicates that the gap between actual and optimal reserves has declined sharply since the 2002 crisis due to a substantial reduction in vulnerabilities. While the results suggest that reserves are now near optimal levels, further accumulation may be desirable going forward, partly because banks' currently high liquidity levels are likely to decline as the credit recovery matures.

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Paper provided by International Monetary Fund in its series IMF Working Papers with number 07/265.

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Length: 24
Date of creation: 01 Nov 2007
Date of revision:
Handle: RePEc:imf:imfwpa:07/265
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  1. Pablo García & Claudio Soto, 2004. "Large Hoardings of International Reserves: Are They Worth It?," Working Papers Central Bank of Chile 299, Central Bank of Chile.
  2. Eduardo Levy Yeyati, 2006. "Liquidity Insurance in a Financially Dollarized Economy," NBER Working Papers 12345, National Bureau of Economic Research, Inc.
  3. Hutchison, Michael M & Noy, Ilan, 2005. "How Bad Are Twins? Output Costs of Currency and Banking Crises," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 37(4), pages 725-52, August.
  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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