The Theory of Reserve Accumulation, Revisited

Discretionary governments may choose to default on their liabilities after issuing new debt, creatingintra-period uncertainty that may raise borrowing costs in a self-fulfilling manner. We show that, toeliminate this disruptive prospect, governments optimally build up reserves to ensure post-auctionrepayment in all circumstances. Intra-period risk naturally provides the foundations for a theory ofreserve accumulation. Optimal reserve policy shields the economy from disruptive (off-equilibrium)risk, substantially containing the costs and size of precautionary debt over-issuance. The modelexplains why governments hold large amounts of reserves and appear reluctant to use them facingfundamental shocks.