International Balance of Payments Financing and Adjustment

This paper explores some implications of the use of national currencies as international reserves. First, a closed economy overlapping-generations model is developed to derive time-consistent tax and inflation policies for a government that is financing a given stream of expenditures. Second, the effects of allowing a government to hold a foreign currency as a reserve asset and to have its currency held as a reserve asset abroad are considered. The use of national currencies as currencies of denomination for international lending creates an incentive for the governments whose currencies are used to alter their inflation rates to extract resources from the rest of the world. When reserves are constrained to be nonnegative the use of national currencies as international reserves raises the inflation rate in reserve issuing countries but does not effect theiInflation rate in reserve holders. The opposite result arises when loans are denominated in the borrowers' currencies.