In a fixed-exchange-rate regime, monetary policy coordination ensures that member countries' money supplies grow at rates compatible with their relative money demands, while foreign exchange reserves act as buffer stocks to absorb short-run deviations of relative money supplies from relative money demands. In Discussion Paper No. 535, Research Fellow Alberto Giovannini assumes that the long-run growth rates of member countries' money stocks are compatible and focuses on the fluctuations of foreign exchange reserves. Current demand for foreign exchange reserves depends on public expectations of currencies' future relative values, which in turn depend on future relative demands for foreign exchange reserves. In equilibrium, an individual country's current demand for foreign reserves depends on its expected future demand for foreign reserves. The level of reserves needed to make the fixed exchange rate credible in the face of shocks to both demands and supplies of money will depend on the rules followed by the country's central bank.

Giovannini develops three two-country models of relative money demand to determine the sensitivity of solutions to the reserves management problem to specific assumptions about the economy and the services supplied by different currencies, i.e. to determine the origin and the effects of currency substitution. In the first two `traditional' models, the cash-in-advance constraint is applied to the goods produced in the two countries, while in the third model cash is required in transactions with the government. Giovannini finds the substitutability of different currencies is critically affected by the fixity of the exchange rate. With a credibly fixed exchange rate, currencies are perfectly substitutable as stores of value, but not necessarily as transactions media if their acceptability as means of payment differs in the member countries of a union. Further, while the total demand for money is always determined, the composition of foreign exchange reserves may be indeterminate if currencies are held for store-of-value purposes only.

Currency Substitution and the Fluctuations of Foreign-Exchange Reserves with Credibly Fixed Exchange Rates
Alberto Giovannini

Discussion Paper No. 535, May 1991 (IM)