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The paper investigates the ability of monetary authorities to keep the real exchange rate undervalued over the long run by implementing a policy of accumulating foreign exchange re- serves. We consider a model of a three-sector, small, open economy, where the central bank continuously purchases foreign currency reserves and compare the results to Russian and Chi- nese economies in recent years. Both countries appear to pursue reserve accumulation policies. We find a clear trade-o between the steady state levels of the real exchange rate and inflation. After calibration, the model predicts an 8.5% real undervaluation of the Russian currency and a 13.7% undervaluation of the Chinese currency. Predicted inflation is found to match observed levels.

The Inflationary Consequences of Real Exchange Rate Targeting Via Accumulation of Reserves