OPTIMAL INTERNATIONAL RESERVES: A STOCHASTIC FRAMEWORK.

In this paper we developed a stochastic model for determining the optimal stock of international reserves. We derived formally the explicit solution for optimal reserve holdings as a function of the rate of interest, the variance of the stochastic process governing international payments and receipts and the mean rate of net payments. The model was tested empirically under the assumption that on average net payments are zero, and the results were consistent with the predictions of the theoretical model. It should be noted, however, that other empirical studies of the demand for reserves, using different specifications and different time periods, have encountered substantial difficulties in incorporating the rate of interest in the estimated reserve equation (for references see Frenkel (1978)). This might indicate that viewing the rate of interest as the measure of forgone earnings may not be always appropriate. Indeed, our own experiments indicate that the estimated parameters are somewhat sensitive to the specification and to the choice of the time period. Therefore, at the present, we view our empirical results only as suggestive. [ABSTRACT FROM AUTHOR]