Abstract
Recent financial crises have heightened the demand from emerging markets' and developing countries’ central banks for international reserves that can meet their emergency foreign currency liquidity needs at times of halts in capital flow. The necessity of reserves for weathering external shocks is well documented in the literature. Likewise, macroeconomic factors to determine the level of reserves have been central to many empirical studies. Motivated by Bangladesh’s stance in regard to reserve accumulation, we aim to investigate the macroeconomic determinants of the demand for international reserves in the country using quarterly data ranging from 1994Q2 to 2016Q4. We also examine the role of disequilibrium in the national money market in reserve movements during the same period. In addition, we check for a structural break associated with the exchange rate regime change in the reserves demand function. The Johansen cointegration test of reserve demand function reveals that the current account vulnerability and exchange rate flexibility play a crucial role in Bangladesh’s long-term reserve demand policies. However, reserves appear to be insensitive to economic size and opportunity cost. A single equation error correction estimate suggests that the monetary disequilibrium does not play a significant role in the short-term reserve movements. More importantly, a dynamic ordinary least-squares estimate suggests that switching to the flexible exchange rate regime in 2003 contributes to a structural change in the long-term reserve demand policies of Bangladesh. Since the empirical results suggest that Bangladesh’s reserve holding behavior is primarily driven by the precautionary motive, we propose that the country should continue to focus on increasing its reserve stock in relation to the current account vulnerability.
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Notes
Other representative interest rates, namely money market rate or 91 day t-bill yield, are not available for the entire period studied.
For more than two variables in a system, Johansen procedure leads to more robust results compared to other procedures.
Monthly data is the highest frequency available in IFS (our main data source). Moreover, ARCH effect tends to die out with lower frequency data. After extracting monthly conditional volatility series, we convert the same to low-frequency quarterly dataset using the “specified in series” method available in Eviews 7. This method essentially allows the points on the low-frequency series to be the average of the corresponding points in the source series (e.g., 1994Q2 point is the average of the points between 1994M04 and 1994M06).
Johansen cointegration test reveals the existence of one cointegrating vector. Hence, we can apply DOLS to estimate the cointegrating vector.
They studied the stability of the money demand function in US for the period 1900–1989.
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Islam, S. Macroeconomic determinants of the demand for international reserves in Bangladesh. SN Bus Econ 1, 34 (2021). https://doi.org/10.1007/s43546-020-00024-7
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DOI: https://doi.org/10.1007/s43546-020-00024-7
Keywords
- International reserves
- Average propensity of import
- Monetary approach to the balance of payments
- Monetary disequilibrium