Exchange Rate Targeting and Gold Demand by Central Banks: Modeling International Reserves Composition

ABSTRACT

This article explores the composition of international reserves under a central bank’s exchange rate policy target. The model allows for numerical estimation of a shadow price of the target exchange rate, interpreted as the central bank’s sacrifice of policy precision for additional unit of portfolio variance or return. The simulations indicate a percentage range gold demand by monetary authority in two regimes under multiple equilibria. Accumulating foreign reserves as precautionary policy suggests increasing shares of gold demand. The central bank would incur greater exchange rate target sacrifice if it wants to achieve higher portfolio returns. The results suggest that ability to target the exchange rate is unaffected by the higher volatility of monthly returns on gold.

KEY WORDS:

• exchange rate anchor
• gold
• international reserves
• monetary policy

Acknowledgments

The authors would like to gratefully acknowledge comments on the earlier drafts by the journal’s editor, Dr. Ali Kutan, three anonymous referees, and our colleagues.

Supplementary Material

Supplemental data for this article can be accessed on the publisher’s website.

Notes

^1. Using a panel regression, Starr and Tran (2008) estimated the determinants of individual demand for gold. They found that limited financial development, cultural valuation, and precautionary motive determine the demand for gold.

^2. It is possible to make F^T and F endogenous to other variables such as fiscal policy or a monetary policy action. We do not believe this is necessary for the task at hand in this article. However, this is one extension to have a direct application of the model to country case studies. This article provides a general framework for studying the question of central bank gold demand under exchange rate targeting.

^3. Throughout this article, we use the term society to emphasize that in small open economies, particularly developing countries, the exchange rate is a much more than a market variable. The exchange rate is the most important price facing everyone.

^4. Looking at the issue of invoicing and trade adjustments, Goldberg and Tille (2006) explain how global invoicing in the dollar dampens the exchange-rate pass through for the United States but amplifies it for the rest of the world. A depreciation of the dollar, however, is more likely to boost American exports but not for the economies whose exports are invoiced in the dollar.

^5. Supplementary Material section is available online and includes the numerical evaluation of the bordered Hessian.

^6. It is possible that a social consensus can develop whereby important segments of a society prefer a pegged exchange rate, as would be the case for several Caribbean economies (Williams 2006).