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Sudden Stops, Productivity and the Optimal Level of International Reserves for Small Open Economies

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  • Alexander Mihailov

    (Department of Economics, University of Reading)

  • Harun Nasir

    (Department of Economics, Zonguldak Bülent Ecevit University)

Abstract

This paper contributes to the theory of optimal international reserves by extending the Jeanne and Rancière (2011) endowments mall open economy (SOE) model to a SOE with capital and production that explicitly accounts for the main sources of economic growth. A first version of our set-up considers capital as the sole factor of production in the spirit of the AK model of endogenous growth with constant population, implying increasing returns to scale and justified on the grounds of its ability to generate sustained long-run growth, as observed empirically. Under a plausible calibration for typical emerging market countries facing the risk of sudden stops in capital inflows, we find that the optimal ratio of international reserves to output is 1.7%, which is quite lower than that in Jeanne and Rancière (2011), of 9.1%, even if calibrated to the same sample of 34 middle-income countries. A richer version then introduces also labour as a second factor in a conventional labour- augmenting Cobb-Douglas production function with constant returns to scale and exogenous population growth, consistent with a long-run balanced growth path and the sustained per capita income growth in the data. Under this alternative technology and the same calibration, we find that the optimal reserves-to-output ratio for emerging market SOEs is 5.5%, almost identical to the 6% obtained by Bianchi et al. (2018) in a different, sovereign debt model without capital and production. We conclude that our results are explained by the role of capital accumulation as precautionary saving: the accumulated capital stock can potentially be used as a pledge to external creditors in obtaining borrowing, therefore insuring better a SOE against sudden stops.

Suggested Citation

  • Alexander Mihailov & Harun Nasir, 2020. "Sudden Stops, Productivity and the Optimal Level of International Reserves for Small Open Economies," Economics Discussion Papers em-dp2020-24, Department of Economics, University of Reading.
    • Handle: RePEc:rdg:emxxdp:em-dp2020-24
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    Cited by:

    1. Alexander Mihailov & Harun Nasir, 2022. "Sudden Stops, Productivity and the Optimal Level of International Reserves for Small Open Economies," Open Economies Review, Springer, vol. 33(5), pages 825-851, November.
    2. Laser, Falk Hendrik & Mihailov, Alexander & Weidner, Jan, 2024. "Currency compositions of international reserves - recent developments," BOFIT Policy Briefs 6/2024, Bank of Finland Institute for Emerging Economies (BOFIT).

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    More about this item

    Keywords

    optimal international reserves; small open economies; sudden stops; production technology; capital accumulation; precautionary saving; insurance contracts;
    All these keywords.

    JEL classification:

    • E21 - Macroeconomics and Monetary Economics - - Consumption, Saving, Production, Employment, and Investment - - - Consumption; Saving; Wealth
    • E23 - Macroeconomics and Monetary Economics - - Consumption, Saving, Production, Employment, and Investment - - - Production
    • F32 - International Economics - - International Finance - - - Current Account Adjustment; Short-term Capital Movements
    • F34 - International Economics - - International Finance - - - International Lending and Debt Problems
    • F41 - International Economics - - Macroeconomic Aspects of International Trade and Finance - - - Open Economy Macroeconomics
    • O40 - Economic Development, Innovation, Technological Change, and Growth - - Economic Growth and Aggregate Productivity - - - General

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