The Optimal Frequency of Adjustment to Balance of Payments Disturbances

Abstract

It is generally presumed in the literature on international liquidity that continuous adjustment to balance of payments disturbances is the optimal intervention policy for a government to adopt. Emil-Maria Claassen has recently questioned this traditional viewpoint [2], and has attempted to show that infrequent or discrete adjustment is a lower cost policy.' This is an important challenge to a generally accepted, but admittedly unexplored, assumption underlying most of the analysis on the demand for international reserves. Claassen has raised a question which must be addressed. Intervention policy must deal simultaneously with different types of disturbances in the balance of payments. However, Claassen's concern is with the optimal adjustment policy only under conditions of balance of payments equilibrium. In this context, which is the conventional approach in the theoretical literature on international liquidity, all balance of payments disturbances are random or stochastic in nature. In the discussion which follows, we will be abstracting from the non-stochastic and non-equilibrium types of disturbances in the balance of payments. This paper will show that, under conditions of fundamental equilibrium, the question of the optimal frequency of adjustment to balance of payments disturbances actually turns on the stochastic pattern of the disturbances. We will define three alternate cases of balance of payments outcomes based upon different possible patterns of disturbances. Then we will determine the lowest cost adjustment policy in each case and consider which case seems to most accurately reflect the real world. Based upon this analysis, it appears that Claassen's findings are valid under one pattern of disturbances only, and this case usually does not hold in the real world. Therefore, continuous adjustment would normally be the optimal intervention policy for governments to adopt.