A different idea for calculating the implicit exchange rate of currencies of nations regarding the U.S. dollar

What is the minimum level of reserve currency that should support the currency of countries?

Index

1. Why did I write this work?

2. What is the implicit exchange rate?

3. A different formula

4. The same mathematical probability applied to deposit/reserve requirements can be applied to money supply/reserve currency relationship

5. What is the percentage of money supply that should be guaranteed by reserve currency?

6. The financial disasters

7. Conclusion

1. Why did I write this work?

Wrote this work because I have seen how in some countries, as Venezuela, has been applied the concept of implicit exchange rate of currency, which has been used as an argument to justify a huge devaluation in that country.

2. What is the implicit exchange rate?

Economists use the concept of implicit exchange rate to determine the relation between the national currencies of countries and the dollar exchange rate. The implicit exchange rate is calculated by dividing the money supply M2 on reserve currency.

Ideally, according to economists, is that the implicit exchange rate matches the real or official rate of exchange so as to ensure the conversion of money supply M2 to dollars when circumstances require; in other words, that all money supply be supported by its equivalent in dollars at the official exchange rate of each country.

3. A different formula

But I think different. I believe it is not necessary that all money supply of countries be backed by reserve currency, but only a part of money supply; I will explain why:

a)    I think the operating system of banking and insurance may be applied, by analogy, to the management system of currencies.

b)   The banking and insurance operates based on the principle of mathematical probability; this principle assumes that all bank customers do not withdraw all their money the same day and all insured do not suffer from diseases or accidents on the same day. There is a regular index of withdrawals from banks and a regular index of diseases and claims of policyholders; those indexes usually represent a historical constant. Those regular withdrawals and claims indexes are altered only in extraordinary conditions such as bank failures or natural disasters.

c)    Well, something similar happens in the administration of currencies of countries because there is a regular rate of foreign exchange transactions; that index usually represents a historical constant. From this fact we can infer that it is not necessary that the entire money supply of a country be guaranteed by reserve currency, because we can assume that all citizens will not go the same day to change their domestic money for foreign currency.

4. The same mathematical probability applied to the deposit/reserve requirements relationship can be applied to money supply/reserve currency relationship

Applying the formula money supply M2/reserve currency to determine the implicit exchange rate of currencies regarding the dollar denies the principle of mathematical probability in which the banking and insurance operation is based, as was explained, because it means to back 100% of money supply with reserve currency, which does not occurs with the deposits of savers in banking. Governments do not consider it necessary to require banks to keep a backup  (reserve requirements or reserve ratio) 1-1 by receiving deposits, but a percentage that varies from country to country, depending on the state of the financial system as a whole. For example, in the United States reserve requirements for deposits over $ 89 million is 10% (January 2014), in Europe the European Central Bank set a reserve of 9,948% for certain types of deposits (April 2014) and in developing countries as Venezuela reserve requirements is 21.5% (July 2014). (1)

I think the same principle of mathematical probability applied to the relationship between deposits and reserve requirements of banks can be applied to the relationship between money supply and reserve currency to support the value of currency and its exchange rate.

5. What is the percentage of money supply that should be guaranteed by reserve currency?

The portion of money supply that must be guaranteed by reserve currency should be determined by the historical evolution of the foreign exchange operations of each country. For example, if the money supply as a whole is the equivalent of 100 billion dollars, and historical foreign exchange operations represent only the equivalent of 50 billion dollars, is this later amount of money supply that must be supported by reserve currency and not all money supply. The application of this concept would facilitate the economic activities of countries because it changes the traditional concept of implicit exchange rate by reducing the amount of money supply that must be backed in reserve currency.

6. Financial Disaster

Banks fail, but it is not usual, in the same way that are not common aviation accidents, because air travel is relatively safe.

The principles in which the operation of the banking and insurance is based usually complies, but when banks fail, governments generally take control and respond to savers. To do this, there are public institutions in most countries whose main objective is to guarantee deposits.

7. Conclusion

Countries can support their national currencies regarding dollar applying the same principle used in deposits/reserve requirements of banks, because it is not necessary backup 1-1 national currencies. Hence, the formula money supply M2/reserve currency should not be the most appropriate to determine the implicit exchange rate of currencies regarding the dollar.

We must say, in conclusion, that only a percentage of the money supply of nations, the corresponding to the historical behavior of its foreign exchange operations is the one that must be backed by reserve currency. From this we can infer that this amount represents the minimum level of reserve currency to support the currency of nations. Obviously, nations may have higher reserves than this minimum amount and higher reserves means higher strength of the economy.

An exception to these assumptions is the countries that use the dollar as its legal tender, as Ecuador, or those countries that keep their national currency in par relation, 1-1 regarding the dollar of the United States of America. The other exceptions are the countries that have higher rates than the dollar of the United States of America, such as the UK and the European Union change.

(1) Sources:

Federal Reserve Bulletin 2014, Volume 100

http://www.federalreserve.gov/monetarypolicy/reservereq.htm

European Central Bank

http://www.ecb.europa.eu/pub/pdf/mobu/mb201407en.pdf Table 1.4

Banco Central de Venezuela

http://www.bcv.org.ve/