Threshold effects of foreign reserve holdings in developing countries

Abstract

Foreign reserves play an important role in insuring developing countries against exogenous shocks and reducing the probability of panic driven crisis. While the literature on foreign reserves has so far focused on determining the 'required' or 'optimal' level of reserves based on various parameters such as volatility of export revenues, opportunity cost of holding reserves etc., little attention has been paid to the impact of reserve holdings in the event of shocks. This paper tries to bring some insight in to the role of reserves in shaping the response of developing countries to exogenous price and capital flow shocks. We find important threshold effects of reserves on the behavior of key macro variables in the face of exogenous shocks. Ignoring these effects would provide us with misleading results regarding the cost of exogenous shocks and adequacy of reserve levels.