| Abstract: |
This paper proposes a theory of foreign reserves as macroprudential policy. We
study an open economy model of financial crises, in which pecuniary
externalities lead to overborrowing, and show that by accumulating
international reserves, the government can achieve the constrained-efficient
allocation. The optimal reserve accumulation policy leans against the wind and
significantly reduces the exposure to financial crises. The theory is
consistent with the joint dynamics of private and official capital flows, both
over time and in the cross section, and can quantitatively account for the
recent upward trend in international reserves. |