The IMF Working Papers series is designed to make IMF staff research available to a wide audience. Almost 300 Working Papers are released each year, covering a wide range of theoretical and analytical topics, including balance of payments, monetary and fiscal issues, global liquidity, and national and international economic developments.
Financially closed economies insure themselves against current-account shocks using
international reserves. We characterize the optimal management of reserves using an
open-economy model of precautionary savings and emphasize several results. First, the
welfare-based opportunity cost of reserves differs from the measures often used by
practitioners. Second, under plausible calibrations the model is consistent with the rule
of thumb that reserves should be close to three months of imports. Third, simple linear
rules can capture most of the welfare gains from optimal reserve management. Fourth,
policymakers should place more emphasis on how to use reserves in response to shocks
than on the reserve target itself.