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### Course: Macroeconomics>Unit 6

Lesson 2: Currency reserves

# Accumulating foreign currency reserves

How and why a central bank would build foreign currency reserves. Created by Sal Khan.

## Want to join the conversation?

• But why do they have to print more money to begin with? Isn't it a good thing for country B that the A's currently are worth less than B's?
• That is good for importers, because it means than people can buy goods from country A, priced in A's, for fewer B's. On the other hand, exporters from Country B will suffer because goods from country B, priced in B's are more expensive for people in Country A to buy with A's currency.

Another way to think about it is to imagine you are going to Europe on vacation. You have calculated that you need 500 euros cash for the trip. The exchange rate is normally 1 Euro/dollar, so you would need 500 dollars to purchase the Euros you needed. If the Federal Reserve buys US treasuries to put more money in circulation and the and the exchange rate is now 1.5 dollars/Euro, you now would need 750 dollars to get the money you needed. But if you were a European citizen looking to come to the US, then instead of needing 500 euros to buy 500 dollars, you would only need 333 euros.
• Why is this situation bad for B? Shouldn't it give holders of B (the citizens of B) more buying power?
• theoretically yes it probably should, but in when you think about it it probably won't because if B citizens try and export anything to A then they will be less competitive to A's domestic producers... thus B's income could decrease :s
• What will happen, when investors stop buying properties or investing their money in B?
What action will take the B's central bank?
• In all likelihood B's Fed would stop printing more B-dollars. However, they probably would not spend their A-dollars to get B-dollars back. If you look at the history of inflationary monetary policy by Keynesian central bankers, they don't really ever roll back their money-printing.
• Since most financial trade is electronic now, and foreign exchange can be conducted faster, in greater quantities, does the central bank of B actually physically "print" the money and physically ship it over to the country A upon completion of transaction? Or does it somehow just "declare" an increase in B currency in its database and merely edit its data files to add a few million more B currency, which it then trades electronically to receive also just a digital receipt of A currency?
• From my knowledge, the US Federal Reserve issues "electronic funds" to its banking partners which are then lent out to the institution's customers. The only time physical currency is transacted in our modern world is when customers (you or I) withdraw money from the bank for cash transactions. My assumption is the Fed has a database of how much currency it distributes to its partner banks when it issues new currency. Of course, the Fed will eventually have to restock currency supplies in banks as it fluctuates or they phase out older denominations, etc.

Unfortunately, this is problematic when the national currency is scrutinized a bit more, especially in light of it being "fiat" and backed by no physical commodity that has market-defined value. All that's theoretically needed to expose this issue is a bank run on several of the partner banks. If too many people ask for their cash at the same time, actual amounts of cash would be incapable of sustaining that demand. Hence exposing the lack of supply (and true value) of that currency. This is what's referred to as fractional reserve banking; ie, the reserve of currency (or even the commodity its backed by) is less than total real demand.
• So is maintaining foreign currency reserves a market distortion?
• In the sense that it is not in the free markets interest yes. Having one central Bank that controls the money supply means that only one party can essentially control the value of an economies currency.
• How does the central bank of country A purchases currency of country B (foreign currency)? By direct purchase on the forex, by buying debt issued by the central bank of country B, i.e. by lending money to country B, or both ways? Cheers
• They tend to buy the currency in the currency exchange markets.
• Sal says that country B buys extra As with the new money printed ... but my question is, even if country B hadn't printed the money, it would still have had the same amount of As, because they would have paid the higher exchange price to get the Bs anyway...

example: if there are 100 As and 100 Bs on the forex market, 1 for 1 and then the situation becomes 200 As want those 100 Bs... B does not have to print extra money to get those 200 As ... as A would have bought those 100 Bs for double the price anyway.... correct?
• You misunderstand the point. The reason that the central bank of B wants to engage in this transaction at all is because B does not want the exchange rate to be 2:1. B wants the exchange rate to remain at 1:1. B doesn't actually care about having foreign currency reserves. The exchange rate is what is important to B.
• In Sal's example of Country B printing more dollars to prevent it's dollars from becoming more valuable relative to Country A, could Country B be accused of being a "currency manipulator"?

Also, by now holding a lot of Country A's dollars, does Country B have a vested interest in the economic health of Country A? If Country B is holding a lot of Country A's dollars, then Country B wants the value of Country A's dollars to not decline too much because then their holdings of Country A's dollars will decline. Is that accurate? Thanks.