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

This paper explores the composition of international reserves under a central bank’s exchange rate policy target. The model allows for numerical estimation of the shadow price – interpreted as the central bank’s sacrifice of policy precision given additional unit of portfolio variance or return – of the target exchange rate. The simulations indicate a two-regime demand for gold. Derived multiple equilibria suggest that the monetary authority could possibly have a wide percentage range of gold demand. Demanding a higher percentage of gold is more appropriate if the central bank prefers to accumulate international reserves for precautionary reason. The central bank would tend to 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