Balance sheet effects, foreign reserves and public policies

Based on a theoretical model, this paper shows that foreign reserves are useful for a country to enhance the resilience of its domestic economy against balance sheet effects in the context of external financing strains. Using foreign reserves, the government can either lend in foreign currency to the private sector or conduct expenditure-switching policy to increase fiscal spending on domestic goods. Both policies cam remove the bad equilibrium represented by a large depreciation of the domestic currency and a very low level of investment. Nevertheless, these two policy tools differ in the ways they stabilize the domestic economy and in terms of the minimum required amount of foreign reserves. A targeted lending works by altering investors’ expectation on domestic exchange rate and firms’ net worth. As long as foreign reserves are sufficient to cover the private sector’s external debt, the bad equilibrium is removed even without an actual depletion of reserves. On the contrary, fiscal spending increases the demand for domestic goods and affects the relative price, leading to domestic exchange rate appreciation that increases firms’ net worth and facilitates investment.