The Inflationary Effects in a Crisis and the Risk Management Strategy with International Reserves

Abstract

This work presents a model of a two-period economy where the household has a CRRA utility function and monetary policy impacts his budgetary constraint. There are two possible states of nature in the second period: a normal state and a crisis state. The policy maker buys an Arrow-Debreu security to insure against crisis. The costs of the Arrow-Debreu security are equal to the costs of holding international reserves. The model considers that the central bank wants to avoid crisis and to smooth inflation and then the main contribution of this paper is to connect monetary policy with the precautionary motivation of holding international reserves. As a result, the framework provides an equation to calculate the level of international reserves and the model calibration shows that the equation can help to evaluate international reserves holdings. The calibration also shows that not considering monetary policy in the risk management strategy can lead to an underestimated amount of international reserves.