(1) under a fixed exchange rate system, what allows a central bank of a currency zone to ensure that payments clear in the short term in the case of imbalances in payments that may require a revaluation if they persist into the longer term.

(2) under a floating exchange rate system, what allows a central bank of a currency zone to intervene in foreign exchange markets to prop up the value of a currency.

When the central bank in (2) is not targeting a specific rate, but is simply intervening to slow down the pace of exchange rate movements, this is called a "dirty float".

If the central bank of a currency zone wishes to maintain a stable exchange rate with another currency, or basket of currencies, then it can do so in the context of a floating exchange rate system by pegging at an undervalued rate (using the indirect foreign exchange rate to simplify the language ... that is, the currency in question as a commodity to be bought and sold in some foreign exchange market overseas somewhere).

Pegging at an undervalued rate is possible because defending against an increase can be done by issuing more domestic currency and using that to purchase foreign exchange.

Pegging at an overvalued rate is not sustainable in the long term, because it requires using foreign exchange reserves, and the central bank of a currency zone has no ability to create new foreign exchange. Since its not sustainable in the long term, it can also attract speculative activity, and since the defense against that speculative activity consumes the foreign exchange reserves at an even faster rate, the speculative attack itself is likely to attract further speculation, creating a "feeding frenzy".

And since pegging means that the exchange rate remains stable, while foreign exchange market valuations are intrinsically volatile, a peg that is "neutral on average" would part of the time be above market valuation ... so to maintain a peg, the discounted peg on the one hand reduces the frequency when the peg has to be defended against falling, and on the other hand results in accumulation of foreign exchange reserves, making speculators less confident that a speculative attack will succeed, making a speculative attack less likely.

Foreign exchange reserves normally only come into attention when there is a capital accounts crisis in a country with a sudden surge of capital outflows ... the immediate impact of that is a collapse in the exchange rate, which can interfere with essential imports (food, fuel, etc.), but the central bank can use the foreign exchange reserves to prop up the exchange rate and slow the decline while the government tries to sort out a more permanent fix.

Also, countries that try to maintain an overvalued exchange rate have to try to capture foreign currency inflows as they occur and ration that currency among competing uses ... they are the countries for whom "x days foreign exchange reserves", means effectively, "x days of hard currency in the bank".

That's what foreign exchange reserves are ... they are used when a central bank is propping up an exchange rate, and accumulated when pushing down exchange rates.  The exception are a range of fourth world countries whose domestic currency is mostly treated as worthless beyond its national borders, for whom foreign exchange reserves are basically the total amount of "international money" that its central bank has available to allow payments for imports and overseas income obligations to be made.


I've been accused of being a Marxist, yet while Harpo's my favourite, it's Groucho I'm always quoting. Odd, that.