what is external reserve?

Question

Its impact on an economy

Answer 1

Same as the home. When you consume less that you produce, you build a reserve. It gets complicated when the reserve you have may not be the "same" value when you want to cash it - depends on what the reserve is denominated. Gold for some time was the common exchange because is is divisible, it is limited in supply, it does not deteriorate over time etc. Will not be the least bit surprised if China with it huge external reserve obtained through its cheap manufacturing and low cost labour is doing exactly that: as its reserve is not at the moment internally consumed. There is an unequal distribution of the wealth created. The reserves are not flowing back to buy US goods because the Dollar is no longer "reliable". The bond is related and so is the "war" funds needed to fight in IRAQ. The question is one of those too complicated to be answered here.

Answer 2

A foreign currency held by central banks and other major financial institutions as a means to pay off international debt obligations, or to influence their domestic exchange rate.
A reserve currency (or anchor currency) is a currency which is held in significant quantities by many governments and institutions as part of their foreign exchange reserves. It also tends to be the international pricing currency for products traded on a global market, such as oil, gold, etc. More recently, however, nations especially in Asia, have been stockpiling reserves in an effort to strengthen export competitiveness by weakening their own currencies, and also to contain quick and large inflows of capital, and buffer against financial crisis such as the Asian financial crisis.Currently, the U.S. dollar is the primary reserve currency used by other countries. A very large percentage of commodities such as gold and oil are usually priced in U.S dollars, causing other countries to hold this currency to pay for these goods. A large debate still continues about whether or not the U.S. dollar will stay the main reserve currency or if it will shift over to the euro.The United States dollar as the most important reserve currency in the world today, shows that from the mid-point of 2006, 65.4% of the identified official foreign exchange reserves in the world were held in United States dollars, 25.4% in euros, 4.2% in pound sterling, and 3.3% in Japanese yen, according to the IMF. For this reason, the US dollar is said to have "reserve currency status", making it possible for the United States to run significant trade deficits (financed by seigniorage) with limited economic impact as long as the major holders of reserve currencies do not issue public statements suggesting otherwise.The pound sterling was the primary reserve currency of much of the world in the 18th and 19th centuries. But perpetual current account and fiscal deficits financed by cheap credit and unsustainable monetary and fiscal policies and the relative decline of Britain from being the world's pre-eminent military and economic power led to the pound losing this status. The Japanese yen has been on the decline as a reserve currency for the past decade. The Swiss franc is often included in the mix as well, due to its perceived stability.The G8 also frequently issues public statements as to exchange rates, though with the exception of Japan, the member states are impotent in their ability to directly affect rates. In the past, however, its predecessor bodies could directly manipulate rates to reverse large trade deficits (see Plaza Accord).The top reserve currency is generally selected by the banking community for the depth, strength, and stability of the economy in which it is used. Thus, as a currency becomes less stable, or its economy shrinks, bankers may abandon it for more stable or deeper economies, although it may take a long time, as recognition is important in determining a reserve currency. For example, it took many years after the United States overtook Great Britain as the financial centre of the world before the dollar became the dominant global reserve currency.
The Euro is already the second most commonly traded reserve currency, and is a strong candidate to displace the dollar as the predominant reserve currency, although it may instead co-dominate. Since the euro was launched in 1999 (largely replacing the Deutschmark as a major reserve currency), its contribution to official reserves has risen continually as banks seek to diversify their reserves and trade in the eurozone continues to expand.[2] Other nations and groups of nations have expressed their desire to see their currencies (or future currencies) be used as reserve currencies, such as Russia, and the Gulf Cooperation Council.Reserve, which is the official public sector foreign assets which are readily available to and controlled by the authorities for meeting a defined range of objectives for a country or union are very important. In this context, a reserve management entity is normally made responsible for the management of reserves and associated risks. Typically, official foreign exchange reserves are held in support of a range of objectives including to:
•support and maintain confidence in the policies for monetary and exchange rate management including the capacity to intervene in support of the national or union currency;
•limit external vulnerability by maintaining foreign currency liquidity to absorb shocks during times of crisis or when access to borrowing is curtailed and in doing so;
•provide a level of confidence to markets that a country can meet its external obligations;
•demonstrate the backing of domestic currency by external assets;
•assist the government in meeting its foreign exchange needs and external debt obligations; and
•Maintain a reserve for national disasters or emergencies. The external reserves that the Central Bank is required to maintain should comprise of all or any of the following:-
(a)gold;
(b) foreign notes and coins;
(c)balances payable on demand held with financial institutions abroad;
(d)bills of exchange and promissory notes denominated in foreign currency;
(e)treasury bills issued by foreign governments, as determined from time to time by the Board;
(f)marketable securities issued or guaranteed by foreign governments or international
financial institutions, as determined from time to time by the Board;
(g)Any internationally recognised reserve asset. One such asset is the IMF Special Drawing
Rights.
The type of assets held, where they are held and in what form give an indication of the principles followed in the management of the country’s foreign exchange reserves. Firstly, as far as possible the assets must be held in liquid form and should be readily available for settling the country’s international transactions. Secondly, foreign exchange in excess of the amounts required for settling the country’s international transactions shall be invested in interest-bearing securities which are marketable and which are likely to appreciate in value and can be liquidated without much capital loss. Thirdly, the assets must be held with reputable and credible financial institutions to ensure they are safe at all times.