Can High Reserves Offset Weak Fundamentals? A Simple Model of Precautionary Demand for Reserves

Apart from exchange rate objectives which have resulted in reserve accumulation as a side effect, Asian countries have chosen explicitly to build up reserves at least in part for precautionary motives. This paper explores the issue of optimal precautionary demand for reserves by a central bank within a context of a simple analytical model. The model suggests that, in general, high reserves can help offset moderately weak fundamentals. However, if fundamentals are sufficiently weak, no level of reserves will be able to counterbalance the weak fundamentals. This is broadly consistent with the escape clause based second-generation models of currency crisis.

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