Optimal Foreign Reserves and Central Bank Policy under Financial Stress

Abstract

We study foreign reserves accumulation and liquidity policy in an open economy under financial stress. Firms and households finance investment and consumption by borrowing from banks, which borrow from abroad. Binding financial constraints cause the domestic interest rate to rise over the world rate and the exchange rate to depreciate, implying inefficiently low investment and consumption. A role emerges for a central bank that accumulates reserves to provide international liquidity when financial frictions bind. Our analysis yields novel insights on the determinants of optimal reserves accumulation cum liquidity provision and their role vis-à-vis capital flow management policies. (JEL E21, E22, E43, E58, F31, F41)