The Liquidity Problem

Efficiency also calls for a certain quantity of official reserves in the system, to act as a kind of universal solvent in the adjustment process.

Like money in the domestic economy, reserves in the international economy perform as a lubricant to reduce economic costs.

Not all payments disequilibria actually require real adjustment. Some simply call for financing by accommodating flows of public and/or private funds.

And indeed, even in those cases where real adjustment is required, the availability of financing can potentially reduce the total cost of the adjustment process.

A second challenge to the monetary order, therefore, is to ensure a supply (and rate of growth) of reserves that is optimal for financing purposes.

This is known as the liquidity problem.

Official monetary reserves are held, because financing requires that governments have access to some kind of stockpile need not be fully owned by each individual country.

National governments could simply rely on induced movements of private short-term capital or on conditional access to public external credit facilities to finance payments imbalances.

In practice, however, such sources have always been regarded as inferior, mainly for political reasons. Governments traditionally prefer to put their faith in reserves that they themselves own.

Reserves are generally defined to include total governmental holdings of gold, convertible foreign currencies, Special Drawing Rights, and net reserve positions in the International Monetary Fund.

The common synonym for official reserves is international liquidity.

Reserve assets play any or all of three monetary roles.

They may be used as a medium of intervention in the foreign exchange market (the intervention role); as a common denominator for expressing currency values (the numeraire role); or as a means of holding wealth (the reserve role).

Historically, few reserve assets have ever monopolized all three of these roles of international liquidity for any significant length of time.

More generally, each role tends to be shared, to a greater or lesser extent, by a variety of reserve assets.

The importance of international liquidity in the monetary order is twofold: first, it determines the ability of governments to finance disequilibria rather than to adjust; and second, it affects the choices that are made between alternative policy options when real adjustment is undertaken.

The problem of liquidity is the task of designing rules and conventions to govern the supply (and rate of growth) of monetary reserves.

Insofar as the efficiency objective is concerned, this is simply another way of describing the challenge to the monetary order to minimize total costs of adjustment in the event of payments disequilibria.