Flexible exchange rates and the need for reserves

["Gunnar Tomasson" <gunnar.tomasson@xxxxxxxxxxx>]

Re-posted.

 

Gunnar

 

 

----- Original Message -----

From: Gunnar Tomasson

To: pkt@xxxxxxxxxxxxxxxx ; paul davidson

Sent: Monday, April 22, 2002 1:30 PM

Subject: Re: Flexible exchange rates and the nned for reserves

Re. the following:

 

In the real world Gunnar's point is not correct even if the government (or central bank) does not attempt to influence the exchange rate in any manner,. Nevertheless, if there is to be an organized and orderly free market in foreign exchange -- there must be "market makers" in order to assure a liquid foreign exchange market. Thus private bankers will have to move in to "make" the market and each of those bankers will have to keep reserves to maintain orderliness. The sum total of all the privately held reserves will exceed that necessary for central banks to maintain a fixed exchange rate.  And these are NEEDED reserves, not  "perceived"  reserves, to assure a liquid, orderly market over time.

 

Comment:

 

The "reserves" data which gave rise to this thread do not include Lines of Credit on which Market Makers - central banks and private bankers - can draw as and when needed to supplement the liquidity represented by their owned Reserve Assets.

 

Also, with the advent of "structural" payments surpluses by major OPEC members in the 1970s, new rules were adopted for the calculation of their official "reserves" whereby massive amounts of what used to be termed "reserves" were designated by another label - Saudi Arabia's holdings of U.S. Treasury Notes and Kuwait's "Fund for Future Generations" come to mind.

 

These are but two reasons why increases in reported "reserves" after the early 1970s are (a) understated, and (b) meaningless for analytical purposes.

 

Gunnar

 

----- Original Message -----

From: paul davidson

To: pkt@xxxxxxxxxxxxxxxx

Sent: Monday, April 22, 2002 11:27 AM

Subject: Flexible exchange rates and the nned for reserves

At 07:55 PM 4/21/02 , Henry Liu wrote:
It seems that there is a confusion about the term flexible exchange rate.
A freely exchangable currency with a traget exchange rate requires more reserves
to hold the target. If there is no target exchange rate, no reserves are needed,
as Gunnar points out.

Only under some very unrealistic conditions, can a logical construct that makes the above point be demonstrated. (but as explained below these conditions cannot exist in the real world.)

In the real world tGunnar's point is not correct even if the government (or central bank) does not attempt to influence the exchange rate in any manner,. Nevertheless, if there is to be an organized and orderly free market in foreign exchange -- there must be "market makers" in order to assure a liquid foreign exchange market. Thus private bankers will have to move in to "make" the market and each of those bankers will have to keep reserves to maintain orderliness. The sum total of all the privately held reserves will exceed that necessary for central banks to maintain a fixed exchange rate.  And these are NEEDED reserves, not  "perceived"  reserves, to assure a liquid, orderly market over time.

Moreover if one or more of the private banker "market makers" were to go bankrupt in an attempt to maintain orderliness in the face of a bandwagon (herd behavior) movement, then there need not exist any set of exchange rates that will clear all markets simultaneously (as Arrow and Hahn have, in their book, demonstrated -- any bankruptcy jeopardizes the existence of any general equilibrium).

The idea that there can exist a free market determined equilibrium exchange rate over time in a changing world economy is a Friedmanic myth -- that requires impossible logical conditions -- as FrIedman admitted when he responded to my criticism in the JPE in 1972 when Freidman wrote" A price may be flexible... yet be relatively stable, because demand and supply are relatively stable overtime (e.g., this was the case with the exchange rate of the Canadian dollar in the 1950s). Violent instability of prices in terms of a specific money would greatly reduce the usefulness of that money...."

It is nice to know that exchange rates can be perfectly flexible as long as demand and supply are stable over time..... The question occurs what should be done when the exchange rate becomes unstable -- and people rush to a different liquidity store of value?
All of this is discussed in great detail in a chapter of my forthcoming book (to be published this summer) FINANCIAL MARKETS, MONEY AND THE REAL WORLD.

Paul