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Balance sheet effects, foreign reserves and public policies

Author

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  • Cheng, Gong
Abstract
Based on a theoretical model, this paper shows that foreign reserves are useful for a country to enhance the resilience of its domestic economy against balance sheet effects in the context of external financing strains. Using foreign reserves, the government can either lend in foreign currency to the private sector or conduct expenditure-switching policy to increase fiscal spending on domestic goods. Both policies cam remove the bad equilibrium represented by a large depreciation of the domestic currency and a very low level of investment. Nevertheless, these two policy tools differ in the ways they stabilize the domestic economy and in terms of the minimum required amount of foreign reserves. A targeted lending works by altering investors’ expectation on domestic exchange rate and firms’ net worth. As long as foreign reserves are sufficient to cover the private sector’s external debt, the bad equilibrium is removed even without an actual depletion of reserves. On the contrary, fiscal spending increases the demand for domestic goods and affects the relative price, leading to domestic exchange rate appreciation that increases firms’ net worth and facilitates investment.

Suggested Citation

  • Cheng, Gong, 2014. "Balance sheet effects, foreign reserves and public policies," MPRA Paper 59905, University Library of Munich, Germany, revised 14 Nov 2014.
    • Handle: RePEc:pra:mprapa:59905
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    3. Collins C. Ngwakwe, 2017. "Analysis of the Role of Export Value on the Reserve of South Africa," Acta Universitatis Danubius. OEconomica, Danubius University of Galati, issue 13(4), pages 5-14, AUGUST.
    4. Hory, Marie-Pierre & Levieuge, Grégory & Onori, Daria, 2021. "Public spending, currency mismatch and financial frictions," Journal of International Money and Finance, Elsevier, vol. 116(C).
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    6. Daniel Hansen, 2023. "The democratic (dis)advantage: The conditional impact of democracy on credit risk and sovereign default," Economics and Politics, Wiley Blackwell, vol. 35(1), pages 356-410, March.

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    More about this item

    Keywords

    Foreign reserves; currency mismatch; balance sheet effects;
    All these keywords.

    JEL classification:

    • F31 - International Economics - - International Finance - - - Foreign Exchange
    • F32 - International Economics - - International Finance - - - Current Account Adjustment; Short-term Capital Movements
    • F41 - International Economics - - Macroeconomic Aspects of International Trade and Finance - - - Open Economy Macroeconomics
    • G01 - Financial Economics - - General - - - Financial Crises
    • H30 - Public Economics - - Fiscal Policies and Behavior of Economic Agents - - - General

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