Why there is a lower bound on the central bank's foreign reserves

This article examines the implications for the balance of payments of imposing a cash-in-advance constraint on financal market transactions. I show that with a welfare-maximizing government this constraint introduces a lower bound on the central bank's net foreign reserves; the depletion of the net foreign reserves below zero results in a welfare loss. I further show that either the private or public sector solvency constraint is violated, if the growth rate ofdomestic credit expansion exceeds a critical magnitude, which is somewhat below the foreign interest rate. Unlike in Buiter (198?), the violation of the solvency constraint does not depend on the way the credit expansion is used. The timing and the size of the speculative attack associated with an anticipated exchange rate regime shift are, however, dependent on the way the credit expansion is injected into the economy.