The accumulation of international reserves under an inflationary pressure

Summary

In this paper we have derived a trade-off relation between the safety level and the terms of trade. The safety level is expressed as one minus the probability of running out of reserves, and the terms of trade measures the excess of the volume of exports over that of imports incurred in the process of reserve accumulation. The trade-off relation depends on the rate of foreign inflation and on the variability of “real” disturbances to the balance of payments. A rise in the rate of inflation or the variability of “real” disturbances will make the country worse off by shifting the trade-off curve. But the welfare loss will be minimized if the authorities manipulate the exchange rate so that the burden is shared by deteriorated terms of trade as well as by decreased safety. This implies that neither the policy of maintaining the safety level nor that of keeping the terms of trade unchanged is optimal, and that the authorities are well advised to strike a balance between the two policies.