Abstract
This paper considers if huge accumulation of foreign reserves by some countries is optimal in a simple, intertemporal, and welfare maximization model with loss aversion. The optimality condition is shown to depend on several underlying parameters of the model. Configuration of output shocks and probability of bad state reveal that, controlling other parameters, huge accumulation of foreign reserves of China and Japan is consistently interpreted as optimal within the model. We also consider if external debts serve as alternative optimal precautionary methods. The optimal precautio-nary saving is also shown to be welfare-enhancing with loss aversion.
Highlights
It has been recognized that foreign reserve accumulation is costly for governments, and the costs must be compensated by the benefits from reserve holding
A special emphasis is given to the probability of bad state, e.g. crisis, and we consider how the national welfare level changes depending on the probability and loss aversion; 3) Third, we offer our new, consistent, interpretation of Chinese and Japanese huge accumulation within an intertemporal welfare-maximizing model with loss aversion
We examine the welfare when a country borrows for fear of a bad state from abroad, and consider the substitutability for reserves; 4) Fourth, completing the present investigation, we consider whether precautionary saving within our simple model with loss aversion is warranted
Summary
It has been recognized that foreign reserve accumulation is costly for governments, and the costs must be compensated by the benefits from reserve holding. If reserve holding is costly, it is puzzling that such huge reserves have been accumulated by some countries, because the demand for reserves was believed to diminish since the advent of the general floating from 1973 Contrary to this prediction, it is a historically observed fact that accumulation grew fast under exchange rate flexibility, known as the Frenkel’s paradox in the literature. 2, the author will present a non-exclusive survey of the recent literature of the optimal reserves examined mainly from the benefit side. We examine the welfare when a country borrows for fear of a bad state from abroad, and consider the substitutability for reserves; 4) Fourth, completing the present investigation, we consider whether precautionary saving within our simple model with loss aversion is warranted.
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