Real exchange rate and international reserves in the era of growing financial and trade integration

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"This paper evaluates the impact of international reserves, terms of trade (TOT) shocks and capital flows on the real exchange rate (REER). We observe that international reserves (IR) cushions the impact of TOT shocks on REER, and that this effect is important for developing but not for industrial countries. This buffer effect is especially significant for Asian countries, and for countries exporting natural resources. As suggested by theory, financial depth reduces the buffer role of IR in developing countries. The role of shock absorber for IR remains robust to the addition of various controls, dealing with capital flows (FDI, hot money, etc.), exchange rate management and monetary policy, as well as trade openness. We also find that short term capital inflows (Other Investment, Portfolio Investment) and increases in foreign reserves are associated with appreciated real exchange rate. Developing countries REER seem to be more sensitive to changes in reserve assets; whereas industrial countries display a significant relationship between hot money and REER and no effect on REER due to changes in reserve assets"--National Bureau of Economic Research web site.

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