International Capital Movements and Monetary Equilibrium: Reply

Abstract

In his conmment on my recent article, H. Robert Heller has focused attention on an important issue-what is the effect on the level of wealth of a sale of capital assets in return for foreign exchange reserves, or more generally, of an increase in the stock of foreign exchange reserves from whatever source? In my paper I assumed for analytical convenience that foreign exchange reserves held by the government are not regarded by individuals in the community as part of their wealth, and then qualified this statement in a footnote, arguing in effect that an accumulation of foreign exchange reserves in exchange for capital assets would reduce wealth, but not by the full amount of the reduction in capital assets. Even if they yield no return in the form of interest such foreign exchange reserves are wealth in the sense that they can be cashed in for real goods or capital assets. If they bear interest, so much the better. This is consistent with the notion, common among trade economists, that surplus countries are giving subsidized loans to deficit countries. The element of subsidy or wealth transfer arises because the reserves are being held in a different form than individuals would choose to hold them, that is, if we were to let the exchange rate float and hand over the stock of foreign exchange reserves on some basis to the members of the community, they would convert them into capital assets at least in part. In his comment, Heller appears to be making three points. First, he argues that government held foreign exchange reserves have a liquidity value in that they enable the authorities to finance balance of payments deficits without undertaking costly adjustments of the domestic economy. Second, he points out that the fraction of the total national wealth portfolio that should be held in the form of foreign exchange reserves is determined by the condition that the marginal liquidity return noted above be equal to the marginal rate of return obtainable on other assets. Third, he concludes that the financing of a balance-of-payments disequilibrium by an accumulation or depletion of foreign exchange reserves involves no transfer of wealth but merely an exchange of assets. In order to respond effectively to these points, I find it useful to develop more fully the theory of the optimal stock of foreign exchange reserves. It is possible, as Heller's argument implies, that some or all members of the community may obtain utility from having some degree of exchange rigidity and some government held inventory of foreign exchange reserves which would provide the liquidity necessary to maintain the desired degree of inflexibility of the exchange rate without requiring inflation or deflation of the domestic economy. Since the raison d'etre of any government policy is that individuals benefit, the analysis must begin at the individual level. Because individuals differ in their economic circumstances and their attitudes toward risk, they will be affected differently by exchange and domestic income and price variability and the degree of uncertainty with respect to the ability of the government to avoid them. The optimal government held stock of foreign exchange reserves will therefore be different for different individuals. In Figure 1, the vertical axis measures the net increment to wealth resulting from the government held inventory of foreign exchange reserves while the horizontal axis measures the mean or permanent size of that inventory. It is the average or permanent stock of foreign exchange reserves rather than the current stock which is relevant, since the function of the stock of reserves is * Professor of economics, University of Toronto.