Corsetti, G., Maeng, S. H.
The Theory of Reserve Accumulation, Revisited
CWPE2370
Abstract: Uncertainty about a government willingness to repay its outstanding liabilities upon auctioning new debt creates vulnerability to belief-driven hikes in borrowing costs. We show that optimizing policymakers will eliminate such vulnerability by accumulating reserves up to ensuring post-auction debt repayment in all (off-equilibrium) circumstances. The model helps explaining why governments hold significant amounts of reserves and appear reluctant to use them to smooth fundamental shocks. Quantitatively, the model explains reserve holdings up to 3% of GDP if debt is short term, 2.4% with long-term debt—as long bond maturities mitigate vulnerability to belief-driven crises.
Keywords: Debt Sustainability, Discretionary Fiscal Policy, Expectations, Foreign Reserves, Self-Fulfilling Crises, Sovereign Default
JEL Codes: E43 E62 F34 H50 H63
Author links: Giancarlo Corsetti Fred Seunghyun Maeng - Winner of CERF best student paper award
PDF: https://www.econ.cam.ac.uk/research-files/repec/cam/pdf/cwpe2370.pdf 
Open Access Link: https://doi.org/10.17863/CAM.104881
