Undervaluation through foreign reserve accumulation: Static losses, dynamic gains

This paper analyzes foreign reserve accumulation as a second-best policy in economies with learning-by-investing externalities that arise disproportionately from the tradable sector. Under closed capital accounts, reserve accumulation requires an increase in net exports, which reduces the domestic supply of tradable goods, raises their relative price in terms of non-tradable goods – i.e. undervalues the real exchange rate – and stimulates the production of tradable goods. The cost of such a policy is to reduce domestic tradable absorption. However, since the tradable sector generates learning-by-investing externalities, it leads to dynamic gains. Reserve accumulation always increases growth in our framework, but the net welfare effects depend on the balance between the static losses from lower tradable absorption and the dynamic gains from higher growth. We capture this trade-off in a simple analytic formula and depict it in an intuitive graph. We also discuss alternative policy options to reserve accumulation that serve to internalize learning-by-investing externalities.