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Economics Project on Significance of Foreign Exchange Reserve Essay Sample

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  • Word count: 1,032
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  • Category: currency

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Introduction of TOPIC

These few holders account for more than 60% of total world foreign currency reserves. The adequacy of the foreign exchange reserves is more often expressed not as an absolute level, but as a percentage of short-term foreign debt, money supply, or average monthly imports.

Foreign-exchange reserves
Foreign-exchange reserves (also called forex reserves or FX reserves) in a strict sense are ‘only’ the foreign currency deposits and bonds held by central banks and monetary authorities. However, the term in popular usage commonly includes foreign exchange and gold, special drawing rights (SDRs), and International Monetary Fund (IMF) reserve positions. This broader figure is more readily available, but it is more accurately termed official international reserves or international reserves. These are assets of the central bank held in different reserve currencies, mostly the United States dollar, and to a lesser extent the euro, the United Kingdom pound sterling, and the Japanese yen, and used to back its liabilities, e.g., the local currency issued, and the various bank reserves deposited with the central bank, by the government or financial institutions.

Purpose
In a flexible exchange rate system, official international reserve assets allow a central bank to purchase the domestic currency, which is considered a liability for the central bank (since it prints the money or fiat currency as IOUs). This action can stabilize the value of the domestic currency.[citation needed] Central banks throughout the world have sometimes cooperated in buying and selling official international reserves to attempt to influence exchange rates. This coordinated strategy was used to replace pound sterling with US dollar as the world reference currency during the 20th century.[1] The lack of such international cooperation is also a big concern for the replacement of US Dollar in this role of reference currency in foreign exchange reserves.[2] Changes in reserves

The quantity of foreign exchange reserves can change as a central bank implements monetary policy.[3] A central bank that implements a fixed exchange rate policy may face a situation where supply and demand would tend to push the value of the currency lower or higher (an increase in demand for the currency would tend to push its value higher, and a decrease lower). In a flexible exchange rate regime, these operations occur automatically, with the central bank clearing any excess demand or supply by purchasing or se

lling the foreign currency. Mixed exchange rate regimes (‘dirty floats’, target bands or

similar variations) may require the use of foreign exchange operations (sterilized or unsterilized[clarification needed]) to maintain the targeted exchange rate within the prescribed limits . Foreign exchange operations that are unsterilized will cause an expansion or contraction in the amount of domestic currency in circulation, and hence directly affect monetary policy and inflation: An exchange rate target cannot be independent of an inflation target.

Countries that do not target a specific exchange rate are said to have a floating exchange rate, and allow the market to set the exchange rate; for countries with floating exchange rates, other instruments of monetary policy are generally preferred and they may limit the type and amount of foreign exchange interventions. Even those central banks that strictly limit foreign exchange interventions, however, often recognize that currency markets can be volatile and may intervene to counter disruptive short-term movements. To maintain the same exchange rate if there is increased demand, the central bank can issue more of the domestic currency and purchase the foreign currency, which will increase the sum of foreign reserves. In this case, the currency’s value is being held down; since (if there is no sterilization) the domestic money supply is increasing (money is being ‘printed’), this may provoke domestic inflation (the value of the domestic currency falls relative to the value of goods and services).

Since the amount of foreign reserves available to defend a weak currency (a currency in low demand) is limited, a foreign exchange crisis or devaluation could be the end result. For a currency in very high and rising demand, foreign exchange reserves can theoretically be continuously accumulated, although eventually the increased domestic money supply will result in inflation and reduce the demand for the domestic currency (as its value relative to goods and services falls). In practice, some central banks, through open market operations aimed at preventing their currency from appreciating, can at the same time build substantial reserves. In practice, few central banks or currency regimes operate on such a simplistic level, and numerous other factors (domestic demand, production and productivity, imports and exports, relative prices of goods and services, etc.) will affect the eventual outcome. As certain impacts (such as inflation) can take many months or even years to become evident, changes in foreign reserves and currency values in the short term may be quite large as different markets react to imperfect data.

Costs, benefits, and criticisms
Large reserves of foreign currency allow a government to manipulate exchange rates – usually to stabilize the foreign exchange rates to provide a more favorable economic environment. In theory the manipulation of foreign currency exchange rates can provide the stability that a gold standard provides, but in practice this has not been the case. Also, the greater a country’s foreign reserves, the better position it is in to defend itself from speculative attacks on the domestic currency. There are costs in maintaining large currency reserves. Fluctuations in exchange markets result in gains and losses in the purchasing power of reserves. In addition to fluctuations in exchange rates, the purchasing power of fiat money decreases constantly due to devaluation through inflation. Therefore, a central bank must continually increase the amount of its reserves to maintain the same power to manipulate exchange rates. Reserves of foreign currency provide a small return in interest. However, this may be less than the reduction in purchasing power of that currency over the same period of time due to inflation, effectively resulting in a negative return known as the “quasi-fiscal cost”. In addition, large currency reserves could have been invested in higher yielding assets.

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