This paper nests the buffer stock model within a standard open-economy model to capture two motives for international reserves accumulation-the insurance motive and the export-led growth motive. The model is solved for two exchange-rate policies, discretion and a rule with escape clause. It illustrates the behavior of international reserves and other macroeconomic variables when the policymaker pursues output and inflation stabilization and recognizes the supply of reserves can constrain the choice of exchange rate and the choice of exchange rate affects the supply of reserves. When output is below potential, it is optimal under both discretion and the rule to adopt a weak currency and promote export-led growth to achieve output and inflation stabilization. This policy leads to reserve accumulation and is consistent with the behavior of China. When reserves are low initially, welfare is higher when the policymaker follows a rule.
ASJC Scopus subject areas
- Geography, Planning and Development