EFFECT OF BILATERAL TRADE RESERVES ON U.S. EXCHANGE RATE AND DEBT

This paper adopts a simple three-equation open economies dynamic linear model to examine relationships among central banking fundamentals: large quantities of foreign international reserves held by China and Japan, bilateral yuan-dollar and yen-dollar exchange rates. US current account balance, federal government budget deficits and public debt. This model built on a global general equilibrium framework is solved by means of dynamic programming method for selection of an optimal rule equation. Results indicate that one percentage point change in contemporaneous international reserves over US GDP accounts for 99.96 percent of variation in yuan-dollar exchange rate and for 98.71 percent of change in yen-dollar rate from 1990/1 to 2006/12. The lagged one-period reserves as well as US twin deficits play insignificant roles. Results also suggest the pattern of impact by China is different from that exerted by Japan since the latter has long been on a floating exchange regime than the former.