The Optimal Level of Reserves for Low-Income Countries: Self-Insurance against External Shocks

This paper develops an analytical framework that helps to quantify the optimal level of international reserves for a small open economy with limited access to foreign capital and subject to natural disasters or terms-of-trade shocks. International reserves allow the country to relieve balance of payments pressures caused by external shocks and to avoid large fluctuations in imports. The paper calibrates the model to two regions—the Caribbean and the Sahel region in sub-Saharan Africa—and assesses the sensitivity of the results. The conclusion is that popular rules of thumb, such as maintaining reserves equivalent to three months of imports, only give imprecise benchmarks.