Undervaluation through Foreign Reserve Accumulation : Static Losses, Dynamic Gains

This paper shows that real exchange rate undervaluation through the accumulation of foreign reserves may improve welfare in economies with learning-by-investing externalities that arise disproportionately from the tradable sector. In the presence o...

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Bibliographic Details
Main Authors:	Korinek, Anton, Servén, Luis
Format:	Policy Research Working Paper
Language:	English
Published:	Washington, DC: World Bank 2012
Subjects:	ABSOLUTE VALUE ACCUMULATION OF CAPITAL ADVERSE SHOCKS AGENCY PROBLEM AGENCY PROBLEMS AGGREGATE CAPITAL STOCK ALLOCATION OF CAPITAL AMOUNT OF CAPITAL BENCHMARK BUDGET CONSTRAINT CAPITAL ACCOUNT CAPITAL ACCOUNT OPENNESS CAPITAL ACCOUNT RESTRICTIONS CAPITAL ACCOUNTS CAPITAL ACCUMULATION CAPITAL ALLOCATION CAPITAL FLIGHT CAPITAL FLOWS CAPITAL FORMATION CAPITAL INCOME CAPITAL INFLOW CAPITAL INFLOWS CAPITAL INVESTMENT CAPITAL MARKET CAPITAL MARKETS CAPITAL OUTFLOW CAPITAL OWNERS CAPITAL SHARE CAPITAL SHARES CAPITAL STOCK CLOSED CAPITAL ACCOUNTS CLOSED ECONOMY COMPARATIVE ADVANTAGE CONSUMERS CONSUMPTION GROWTH COST OF INVESTMENT CRRA CURRENCY CURRENT ACCOUNT CURRENT ACCOUNT BALANCE CURRENT ACCOUNT DEFICITS CURRENT ACCOUNT SURPLUS DEPRECIATION DEPRECIATION RATE DEVALUATION DEVELOPING COUNTRIES DEVELOPMENT ECONOMICS DIFFERENTIAL TAXATION DISCOUNTED VALUE DISTORTION DISTORTIONS DOMESTIC CAPITAL DOMESTIC CONSUMPTION DOMESTIC CURRENCY DOMESTIC ECONOMY DOMESTIC INTEREST RATE DOMESTIC INTEREST RATES DOMESTIC PRICE DUTCH DISEASE ECONOMIC DEVELOPMENT ECONOMIC GROWTH ECONOMIC IMPLICATIONS ELASTICITY ELASTICITY OF SUBSTITUTION EMERGING ECONOMIES EMERGING MARKET EMERGING MARKET COUNTRIES EQUILIBRIA EQUILIBRIUM EQUILIBRIUM CONDITION EQUILIBRIUM CONDITIONS EXCHANGE RATE DEVALUATION EXPENDITURE EXPENDITURES EXPORT SUBSIDIES EXPORT SUBSIDY EXTERNALITIES EXTERNALITY FACTOR MARKETS FAIR TRADE FINANCIAL ASSETS FINANCIAL SUPPORT FISCAL POLICY FOREIGN DIRECT INVESTMENT FOREIGN INTEREST FOREIGN INTEREST RATES FOREIGN INVESTMENT FOREIGN RESERVE FOREIGN RESERVES FRAUD FREE TRADE GDP GENERAL EQUILIBRIUM GENERAL EQUILIBRIUM MODELS GLOBAL ECONOMY GOVERNMENT EXPENDITURE GOVERNMENT FINANCES GOVERNMENT INTERVENTION GOVERNMENT INVESTMENT GOVERNMENT POLICIES GOVERNMENT POLICY GOVERNMENT REVENUE GOVERNMENT SPENDING GROWTH MODELS GROWTH RATE GROWTH RATES HOLDING HOLDINGS HUMAN CAPITAL IMPORT IMPORT TARIFF IMPORT TARIFFS IMPORTS INCOME INCOME EFFECT INCREASING RETURNS INCREASING RETURNS TO SCALE INDIFFERENCE CURVES INFANT INDUSTRY ARGUMENT INFLATION INSTITUTIONAL CAPACITIES INSTITUTIONAL CAPACITY INSTRUMENT INSURANCE INTANGIBLE INTEREST INCOME INTEREST RATE INTEREST RATES INTERNATIONAL BANK INTERNATIONAL ECONOMICS INTERNATIONAL INTEREST INTERNATIONAL INTEREST RATE INTERNATIONAL PRICE INTERNATIONAL TRADE INVESTING INVESTMENT EXPENDITURES INVESTMENT OPPORTUNITIES INVESTMENT RATE LABOR MARKET LDCS LEVEL OF INVESTMENT LEVIES MACROECONOMICS MARGINAL PRODUCT MARGINAL PRODUCTIVITY MARKET CONDITION MARKET EQUILIBRIUM MARKET INTEREST RATE MARKET POWER MARKET PRICE MARKET PRICES MERCANTILISM MONEY HOLDINGS MULTILATERAL TRADE NATURAL RESOURCE NATURAL RESOURCES NEGATIVE EXTERNALITIES NET EXPORTS NOMINAL EXCHANGE RATE OPEN ECONOMY OPTIMAL ALLOCATION OPTIMIZATION ORGANIZATIONAL CAPITAL POLICY RESPONSES POLITICAL ECONOMY PREVAILING MARKET PRICES PRIVATE CAPITAL PRIVATE CAPITAL STOCK PRIVATE INVESTMENT PRIVATE INVESTMENTS PRODUCTION FUNCTION PRODUCTION FUNCTIONS PRODUCTIVE INVESTMENT PRODUCTIVITY PRODUCTIVITY GROWTH PROFIT MAXIMIZATION PUBLIC GOOD PUBLIC INVESTMENT PUBLIC ¯ SPENDING RATE OF RETURN RATES OF RETURN REAL COST REAL EXCHANGE RATE RELATIVE PRICE RELATIVE WEIGHTS RESERVE RESERVE ACCUMULATION RESERVES RETURN SAVINGS RATE SAVINGS RATES SEIGNIORAGE SLOW GROWTH SPECULATIVE CAPITAL INFLOWS STEADY STATE SUBSTITUTION EFFECT SUPPLY OF CREDIT TAX TAX CREDIT TAX POLICY TAX RATE TAX RATES TAXATION TOTAL OUTPUT TRADABLE GOOD TRADABLE GOODS TRADE AGREEMENTS TRADE DEFICIT TRADE POLICY UNDERVALUATION UTILITY FUNCTION WAGES WORLD ECONOMY WORLD INTEREST RATE WORLD MARKET WTO
Online Access:	http://www-wds.worldbank.org/external/default/main?menuPK=64187510&pagePK=64193027&piPK=64187937&theSitePK=523679&menuPK=64187510&searchMenuPK=64187283&siteName=WDS&entityID=000158349_20100325103944 http://hdl.handle.net/10986/3737

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Summary:	This paper shows that real exchange rate undervaluation through the accumulation of foreign reserves may improve welfare in economies with learning-by-investing externalities that arise disproportionately from the tradable sector. In the presence of targeting problems or when policy choices are restricted by multilateral agreements, first-best policies such as subsidies to capital accumulation, or subsidies to tradable production are not feasible. A neo-mercantilist policy of foreign reserve accumulation "outsources" the targeting problem or overcomes the multilateral restrictions by providing loans to foreigners that can only be used to buy up domestic tradable goods. This raises the relative price of tradable versus non-tradable goods (i.e. undervalues the real exchange rate) at the static cost of temporarily reducing tradable absorption in the domestic economy. However, since the tradable sector generates greater learning-by-investing externalities, it leads to dynamic gains in the form of higher growth. The net welfare effects of reserve accumulation depend on the balance between the static losses from lower tradable absorption versus the dynamic gains from higher growth.

Undervaluation through Foreign Reserve Accumulation : Static Losses, Dynamic Gains

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