The theory of reserve accumulation, revisited

Discretionary governments may choose to default on their liabilities after issuing new debt, creating intra-period uncertainty that may raise borrowing costs in a self-fulfilling manner. We show that, to eliminate this disruptive prospect, governments optimally build up reserves to ensure post-auction repayment in all circumstances. Intra-period risk naturally provides the foundations for a theory of reserve accumulation. Optimal reserve policy shields the economy from disruptive (off-equilibrium) risk, substantially containing the costs and size of precautionary debt over-issuance. The model explains why governments hold large amounts of reserves and appear reluctant to use them facing fundamental shocks