Exchange-Rate Flexibility and Reserve Use

This paper examines whether, as has usually been assumed, there is a trade-off between the degree of flexibility in exchange rates and the extent of reserve use. The first section of the paper constructs a measure of reserve use in order to examine changes in the extent of reserve use since the advent of generalized floating. It is found that reserve use initially tended to increase following the move to floating, and that, despite some subsequent decline, it has remained substantial. The second section constructs and partially solves a formal model designed to illuminate the determinants of reserve use. It is shown that there need not necessarily be a trade-off between exchange-rate flexibility and the extent of reserve use.