A Macroprudential Theory of Foreign Reserve Accumulation

Fernando Arce

Julien Bengui

Javier Bianchi, Senior Research Economist

August 2019 | Federal Reserve Bank of Minneapolis Working Paper 761

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 over-borrowing, 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.

DOI: https://doi.org/10.21034/wp.761