Demand for international liquidity : the developing countries.
Creators: name: Otchere, Danny Kit
Publisher: name: University of British Columbia
Year: 2011

description: The following analysis is an attempt to apply some of the concepts of current monetary theory to the question of demand for international liquidity. The essay is, however, limited to the liquidity and development problems of developing countries. Available statistical evidence for the period between 1951 and 1964 indicates that the developing countries, excluding the major oil-producing countries, have experienced a continued decline in their ratios of reserves to imports -a common measure of the "adequacy" of international reserves. This trend, it has been suggested, seems to imply that the developing countries have been facing a liquidity crisis of their own, quite apart from the more widely discussed problem of the inadequacy of international liquidity in the world context. Various explanations for this liquidity crisis have been offered, all of which seem to fall into one of three categories: viz., what may be termed as a) the "profligacy" hypothesis, b) the "stage of growing pains" hypothesis, and c) the "primitive" rational choice hypothesis. Not all economists agree on which hypotheses are important; neither are they sure of the exact relation between them. In our analysis, the first hypothesis is rejected for not doing full justice to the analysis of the problems involved; on the other hand, the other two are accepted as suggestive but incomplete since they are not bound together into any consistent theory. It is the purpose of this essay to develop a consistent theoretical structure based on the alternative hypothesis that: "as a matter of circumstantial policy", it might be rational choice on the part of a developing economy to utilize some of its accumulated stock of reserves to finance development expenditures. Our analysis starts from the proposition that a monetary authority (developing country) can choose a level of reserves it will hold. As a result, if the drawing down or accumulation of reserves is a deliberate action on its part, then in principle, a demand function for reserves can be specified. Of course, the "primitive" rational choice model suggests this but our main contribution lies in the extension of their framework by applying that branch of monetary theory known as the theory of portfolio selection. In this way, we are able to base the whole analysis of the demand for reserves on the theory of the precautionary demand for money in a world of uncertainty. Our basic approach, therefore, differs from that of the more common analyses which are based on a flow approach of the transaction demand for money, e.g., the quantity theory of money. Indeed, the application of the portfolio theory offers the interesting paradoxical result that the developing countries have a low precautionary demand for reserves even though their reserve needs seem to be great. It is further found that by maintaining low reserve levels, these countries choose a risky portfolio; but that such a choice might be a rational economic behaviour because there is a simultaneous expectation that, other things being equal, drawing down reserves to finance investment in capital formation may lead to future increases in per capita consumption. No attempt is made to subject our alternative hypothesis to any testing. That presently will lie outside the scope of this essay. From a policy standpoint, however, the alternative hypothesis suggests that the quantity of reserves demanded at a particular moment of time can affect the terms on which some developing countries will invest in capital formation (that is, finance development expenditures), although it is not only this variable that can do so. Secondly, it demonstrates that, given the growth problems of developing countries, it might pay if the monetary authorities utilize some of the country's accumulated stock of reserves to finance development expenditures. Finally, we conclude that the costs of development in developing countries can be minimized if more liberal measures were effected to provide for a larger inflow of capital aid to these countries both from developed countries and other international institutions concerned with development aid. The same notion applies to the policies underlying these countries' drawings in the credit tranches at the International Monetary Fund.