Demand for International Reserves

1. Demand for International Reserves Ji Kim

2. Demand for International Reserves • The bank’s assets • Domestic government bonds • International reserves • Role of International Reserves • Can be traded to foreigners for goods • Help on financial crises • When the value of domestic assets decrease

3. Basic Model Assumptions • Domestic and foreign bonds are perfect substitute • Exchange rate is fixed • Absolute confidence in the fixed EXRA • Individual central banks can acquire all the international reserves they need • Monetary policy is ineffective

4. Gold Standard • Gold has been treated as international asset • Debate whether the U.S.D. can play role as international asset today • Euro is the strongest challenger to the dollar

5. Benefit of Holding International Reserves • International reserves utilized to cover a sudden drop in export earnings

6. Influences to Demand on International Reserves • The variability levels of exports, imports, and international financial flow • Thus, higher economic openness leads to lower demand for international reserves • Openness makes adjustments easier • On the other hand, higher openness might cause an economy to become more vulnerable which will increase the demand • Foreign trade shock

7. Cost of Holding International Reserves • Loss of interest on the domestic bonds • Earns the interest on dollars instead • International reserves may offer lower interest rate due to their higher liquidity

8. Flexible Exchange Rates and Demand for International Reserves • In 1960s, theoretically countries with more flexible exchange rate could generate export surplus with low running international reserves • Theoretically, they could depreciate their currencies to avoid recession • In early 1970s, the industrial countries moved to floating exchange rate • Economists expected that demand for the reserves would drop substantially

9. However, industrial-country reserves have grown as the same pace as the nominal industrial-country income

10. 1982-1992, the sharp decline in developing-country reserve is influenced by an international debt crisis during the years 1982-989 • Developing country with flexible EXRA might need to pay off foreign creditors and domestic residents with dollar to avoid a financial crisis and currency collapse

11. The Variability and Demand for International Reserves • The variability in the balance of payment still influence the demand for international reserves. • Today's, huge increase in potential variability and in the potential risks of variability • Caused by rapid globalization of financial markets in recent years