A Welfare Analysis of 'New Mercantilist' Foreign Reserve Accumulation

Abstract

Contrary to traditional neoclassical growth models, recent decades have seen a number of developing economies running sizable current account surpluses. In response to "new mercantilist" explanations of this phenomenon that relate holdings of foreign assets to higher levels of economic growth, this paper presents a theoretical model of a small open developing economy that permits a welfare analysis of mercantilist policies and importantly answers the question of whether mercantilist motives alone can explain the recent high levels of observed foreign asset holdings. Using a calibration to match the characteristics of China, the model predicts that while such policies may lead to significant welfare gains, consumers' desires to smooth consumption generally preclude a positive current account balance under most parameterizations. Deliberate foreign asset accumulation may be welfare reducing or mercantilist motives may provide only one component of a fuller explanation.