Exchange rate variability, the demand for international reserves and dynamic adjustment

The move of international monetary system to floating was viewed in part, as an avenue by which, undue pressure placed on reserves by the par value system could be relieved. On the surface, reserves appear to have increased universally as exchange rates have become more flexible. This observation cast serious doubt on the theoretical expectations of the proponents of flexible rates. This study is an empirical investigation into the different aspects of the relationship between international reserve holdings and exchange rate variability.; First of all, it is pointed out that while it is true that reserves are held for purposes of intervention, it must be recognized that there are other motives for holding reserves that do not seem to have changed or may even have intensified with the move to floating. According to this study, reserve demand is a stable function of three specific factors: the scale of desired transactions, a measure of balance of payments variability and a measure of exchange rate flexibility.; The basic thesis of the study is that the move of the international monetary system to flexible rates significantly decreased the demand for reserves. The results indicate that for both DCs and LDCs, increased exchange rate flexibility has depressed the demand for reserves.; It is also shown that actual reserves adjust to their desired levels at relatively high speeds in contrast to the findings of previous studies and that the dynamic process is enhanced by more flexible exchange rates. Evidence from DCs supports the hypothesis that the speed at which actual reserves adjust to their desired level is positively related to the excess demand for reserves while the results for LDCs appear to be influenced by the relative size of the deficit.; The results of the causality tests demonstrate the exchange rate variations cause changes in reserve levels, reinforcing the idea that countries that wish to replenish their reserve holdings are able to use the exchange rate as an effective tool for controlling reserve levels. (Abstract shortened with permission of author.)...