DP6693 Financial Stability, the Trilemma, and International Reserves

Author(s): Maurice Obstfeld , Jay C Shambaugh , Alan M. Taylor

Publication Date: February 2008

Date Revised: July 2008

Keyword(s): banking crises , capital flight , central banks , exchange rate regimes , financial development , foreign exchange , global imbalances , Guidotti-Greenspan rule , international liquidity , intervention , lender of last resort , net foreign assets , sterilization , sudden stop

JEL(s): E44 , E58 , F21 , F31 , F36 , F41 , N10 , O24

Programme Areas: International Macroeconomics

Link to this Page: www.cepr.org/pubs/dps/DP6693.asp.asp

The rapid growth of international reserves|a development concentrated in the emerging markets|remains a puzzle. In this paper we suggest that a model based on financial stability and financial openness goes far toward explaining reserve holdings in the modern era of globalized capital markets. The size of domestic financial liabilities that could potentially be converted into foreign currency (M2), financial openness, the ability to access foreign currency through debt markets, and exchange rate policy are all significant predictors of reserve stocks. Our empirical financial- stability model seems to outperform both traditional models and recent explanations based on external short-term debt.