M.Sc Student | Dan Lederman |
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Subject | International Reserves and Monetary Policy |

Department | Department of Industrial Engineering and Management |

Supervisor | Full Professor Bar Ilan Avner |

There is massive buildup of foreign reserves in recent years. At the end of 2004, foreign governments held $1.2 trillion of U.S. treasury securities, almost double the $609 billion held in 2000. This buildup was accelerated in the aftermath of the 1997 Asian financial crisis. Countries such as Korea, Taiwan and Chile have managed to build up large stockpiles of foreign-currency reserves in recent years. Japan has more than 800 billion dollars and Israel has about 25 billion dollars.

A major line of research that attempts to explain the amount of reserves that central banks should hold is the buffer stock model. According to this model, the objective of the central bank is to minimize the cost associated with holding and managing reserves. Other objectives that the central bank might have are not explicitly modeled.

In this paper we attempt to combine foreign reserves into a standard dynamic monetary model, the model of Clarida et al. (1999). The central bank uses monetary policy to stabilize inflation and output, its standard goals. However, the bank is also aware of the effect that monetary policy might have on the accumulation or depletion of reserves. The outcome is joint determination of monetary policy and level of foreign reserves.

We introduce a constraint on the minimum amount of reserves and allow reserves to be positively correlated with interest rates. A myopic central bank sets the interest rate at the optimal, unconstrained rate that ignores the reserves constraint, if this rate satisfies the constraint; otherwise, it sets the interest rate at the minimum level that satisfies the constraint. Forward-looking central bank, on the other hand, sets higher interest rate than the myopic bank, and correspondingly accumulates more reserves. This strict monetary policy is costly in terms of contemporaneous stabilization. On the other hand, the additional precautionary reserves allow future monetary policy to be less costly and better stabilizer. Moreover, these additional reserves reduce the probability of a future financial crisis when the level of reserves will be insufficient.

Given the complexity of the model the solution and detailed analysis of the effect of various parameters is carried out by numerical simulations. Our numerical solution demonstrates that these precautionary reserves could be quantitatively significant. Our model contributes therefore to the understanding of why central banks, in particular those which are more vulnerable to a financial crisis, accumulate large amounts of foreign reserves.