An economic evaluation of proposed copper buffer stock agreements on the optimal level of international reserves of Chile
Smith, Gordon W.
Master of Arts
In the literature of optimal international reserves, a formula has been derived explaining the average level of reserves over a period as a function of the standard deviation of export earnings, the opportunity cost of reserves, the costs of adjusting to balance of payments imbalances, and the government's preferences between income levels and income variability. The formula represents 'optimal reserves' in that the government's utility function has been maximized subject to the constraints faced. It has been shown that LDCs experience greater export instability than do developed countries and many economists believe this puts them at a disadvantage for development purposes. As a partial solution, especially for countries which rely on only one or two primary commodities for the bulk of their export earnings, commodity buffer stock agreements have often been advocated as a way of decreasing this instability. Copper is one commodity under consideration for such an agreement while Chile relies on copper for approximately 75% of its export earnings. Using an econometric model of the world copper market, researchers have simulated price and production levels of copper over the period 1955 to 1974 had a buffer stock agreement been in effect. Using two of these simulations, the new standard deviation of Chile export earnings has been figured and inserted into the formula of optimal reserves. The results from the second and most important simulation used in this study, indicate that the average 'optimal' level of reserves would have decreased from $153.41 million to $18.78 million (US dollars of 197) for the twenty year period. This result indicates that a buffer stock operation for copper, with well chosen decision rules, would have enabled Chile to substantially reduce the average level of international reserves held from 1955 to 1974. It was estimated that Chile would have earned $287.65 million by the end of 1974 by investing funds which otherwise would have been held as reserves at their opportunity cost, assuming that the opportunity cost is 1%. If the opportunity cost of Chilean reserves had been only 5% during this period, the gain to the Chilean economy would have been $82.27 million, while if the opportunity cost of reserves had been 15%, the gain to the Chilean economy would have been $722.18 million (all dollar figures are in US dollars of 197).