Optimal level of reserve holding: an empirical investigation in the case of Albania

This discussion material analyses the change in international reserve holdings and their determinants, and evaluates their optimal level from a cost opportunity perspective. The material is based on the Buffer Stock model. This model assumes that reserve holdings are affected by changes of payments and receipts in the balance of payments. Reserves serve as a buffer stock to accommodate fluctuations of external transactions. The focus of the model is to estimate the optimal level of reserves against possible exogenous shocks or a crisis, particularly fluctuations of foreign capital inflows, mainly remittances. The volatility of reserve holdings is generated by Autoregressive Conditional Heteroskedasticity (ARCH) estimation, while the Buffer Stock model is estimated with an ARDL approach. Results indicate a negative relationship of reserve holdings with opportunity cost, volatility and deviation of exchange rate from the trend and positive relationship with imports. The approach estimation suggests that the level of optimal reserve holdings is more sensitive to precautionary rather than mercantilist motives.