Is Large Foreign Reserve Accumulation Sustainable When Interest Rates are Bounded at Zero?

Project: Research

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This project aims to study the impact of explosive foreign exchange reserve accumulation on the sustainability of monetary policy targets. Several emerging economies, including China and Colombia, have experienced large current account surpluses and accelerating foreign exchange reserve accumulation in recent years. This has been accompanied by economic booms, exchange rate appreciations and in some cases increases in domestic inflation. The current account surpluses have led to explosive central bank foreign exchange accumulation, to the point that reserves now exceed what is required for liquidity purposes by a wide margin.The upward impact of foreign exchange accumulation on the domestic money growth makes the central bank very difficult to control the interbank nominal interest rate, which starts to significantly undershoot the target policy interest rate. In order to maintain the monetary policy target, the central bank will have to sterilize the impact of foreign exchange accumulation on the domestic interest rate by selling domestic currency treasury bills. (For example, if a central bank buys foreign exchange to counteract appreciation of the exchange rate under an exchange rate targeting regime, base money will increase. To sterilize the increase, the central bank must also sell government debt to counteract the monetary base by an equal amount.) However, the sterilization soon becomes unsustainable when the central bank runs out of domestic currency treasury bills required for sterilization, and the central bank’s net creditor position vis-a-vis the financial sector soon turns into a net debtor position. As a result, exchange rate appreciation and interest rate decline continues unchecked, which ultimately leads to a collapse of the existing monetary regime when the nominal interest rate reaches its lower bound.While there have been much research in the balance-of-payments crises literature on the effects of having too little foreign exchange, few studies have investigated the effects of accumulating too much foreign exchange on the sustainability of the existing policy targets. This project develops a general equilibrium model to investigate the sustainability of the central bank monetary targets when there is rapid foreign exchange accumulation and the nominal interest rate is bounded at zero. In particular, three monetary policy regimes are examined: the inflation targeting regime, the exchange rate targeting regime and the domestic price level targeting regime. The dynamic paths of the major economic variables at the end-phase of the collapse of the existing monetary regime are also analyzed.


Project number9041615
Grant typeGRF
Effective start/end date1/10/1027/02/13