Markets provide a widely used solution to the problem of allocating resources among the members of the economy. A market equilibrium is individually optimal and clears the markets. The efficiency of competitive market allocations is what makes them desirable.
China’s official foreign exchange reserves are on track to reach the two trillion dollar mark, equivalent to approximately $2000 for every Chinese citizen. Although China is currently the country with the largest foreign reserve accumulation, reserves have risen dramatically for many developing countries in recent years. Economic models suggest a number of motivations for reserve accumulation, including precautionary and mercantilist motives, which may be especially compelling for developing countries. However, the recent upsurge in reserve accumulation among developing countries cannot be explained solely on the basis of these rationales. This paper examines a potential new role for reserve accumulation in helping to mitigate distortions created by the undeveloped financial markets of developing countries.
The growth and liberalization of financial markets in industrial countries over the past three decades provides developing countries unprecedented access to international capital markets, and exposes them to sometimes dramatic and sudden swings in capital flows. The 1990s witnessed a number of economic crises in developing countries that were accompanied by (if not precipitated by) outflows of international capital. This recent experience with capital flow reversals can, at least in part, explain the desire by developing countries to decrease their dependence on international capital by accumulating foreign reserves.
This paper analyzes a search model with asymmetric information of the common value variety. The basic features of this environment resemble those of a common value (procurement) auction, except that the searcher in our model, who is the counterpart of the auctioneer in the auction model, encounters trading partners through costly sequential search.
