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This paper develops a cost-benefit approach that helps to quantify the optimal level of international reserves in low-income countries, focusing on the role of reserves in preventing and mitigating absorption drops triggered by large external shocks. The approach is applied to a sample of 49 LICs over the period 1980-2008 to yield estimates of the likelihood and severity of a crisis. The calibration results suggest that the standard metric of three months of imports is inadequate for countries with fixed exchange rate regimes. The results also highlight the role of overall policy frameworks and availability of Fund-support in determining optimal reserve levels, raising questions about the uniform applicability of standard rules of thumb across countries.

Exports and Imports --- Financial Risk Management --- Foreign Exchange --- Banks and Banking --- Macroeconomic Analyses of Economic Development --- Development Planning and Policy: Trade Policy --- Factor Movement --- Foreign Exchange Policy --- Trade: General --- Financial Crises --- Monetary Policy --- Currency --- Foreign exchange --- International economics --- Economic & financial crises & disasters --- Banking --- Exchange rate arrangements --- Conventional peg --- Exchange rate flexibility --- Imports --- Financial crises --- International trade --- Reserve positions --- Central banks --- Foreign exchange reserves --- United States