Reserves Over the Transitions to Floating and to Inflation Targeting: Lessons From the Developed World

Abstract

This paper highlights the evolution of official international reserves in developed countries that transited towards Inflation Targeting (IT) and/or floating exchange rates. We find several results that are of interest to policymakers in emerging countries, such as Brazil, Chile and Mexico, which have revamped their monetary and exchange rate arrangements along those lines. First, the adoption of a floating exchange rate and an IT framework are associated with a persistent 10% to 20% reduction in real official reserves held at the Central Bank. Second, this reduction in official reserves corresponds mainly to a reallocation of international liquidity towards the private financial sector, that accommodates part of the effect on the level or composition of the net foreign asset position of the countries. Third, there is a clear change in the correlation between interest rate differentials and the dynamics of official reserves, strongly supporting the Mundell-Fleming result regarding the exogeneity of money supply under floating exchange rates. Fourth, the latter also shows that, once constraints on exchange rate volatility are removed, the stock of reserves can be determined independently by the Central Bank, according to cost-benefit analysis, without hindering the credibility of the combination of a floating regime and inflation targeting.