Central Bank Signaling and Optimal Precautionary Credit Lines

Abstract

We develop a DSGE model for a small open economy that incorporates a Flexible Credit Line (FCL) for extending foreign exchange reserves. The economy pays a commitment fee and benefits from a safeguarding mechanism that signals strong fundamentals the rest of the world, thus reducing its risk premium. Conditional on the occurrence of tail-risks, the central bank draws from the FCL to fulfill its financial obligations.

While central bank reserve management has long been studied in economic literature, there is a pending agenda to assess optimal crisis-prevention and crisis-mitigation strategies through precautionary instruments. We develop a DSGE model for a small open economy that incorporates a Flexible Credit Line (FCL) for extending foreign exchange reserves. The economy pays a commitment fee and benefits from a safeguarding mechanism that signals strong fundamentals the rest of the world, thus reducing its risk premium. Conditional on the occurrence of tail-risks, the central bank draws from the FCL to fulfill its financial obligations. We derive optimal conditions for central bank's arrangements with the IMF for such instrument. Furthermore, we estimate the model for the Mexican economy and perform a series of tests with external shocks. Using data from the IMF's External Sector Report, we extend the analysis to study whether other candidate countries could benefit from this instrument.

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Raúl A. Castro Corona
Graduate Student in Economics, Massachusetts Institute of Technology (MIT)

My research interests include political economy, economic development, and international economics.

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