Welfare-Enhancing Accumulation of Foreign Reserves

This paper considers if huge accumulation of foreign reserves by some countries is optimal in a simple, intertemporal, and welfare maximization model with loss aversion. The optimality condition is shown to depend on several underlying parameters of the model. Configuration of output shocks and probability of bad state reveal that, controlling other parameters, huge accumulation of foreign reserves of China and Japan is consistently interpreted as optimal within the model. We also consider if external debts serve as alternative optimal precautionary methods. The optimal precautio-nary saving is also shown to be welfare-enhancing with loss aversion.