The Reserve Bank of Australia has applied Milton Friedman’s profit test in a paper on its foreign exchange intervention operations. The premise underlying the profit test is that to survive, a speculator must, on average, make a profit, and to make a profit they must buy when the price is below its equilibrium or alternatively sell when the price is above equilibrium, which in both cases means conducting a transaction that supports the price moving towards equilibrium. Applying this reasoning to central bank’s interventions, if the bank makes a profit on its foreign exchange dealings it can then claim to be responsible for stabilizing the exchange rate.
Since the float of the Australain Dollar 20 years ago, the RBA has made a profit of A$5.2 billion on its intervention operations, and so the paper concludes that the RBA has had a stabilizing influence on the exchange rate.
Since Friedman devised the test a number of counterexamples have been raised but these are mostly of theoretical interest and unlikely to hold more than occasionally.
A more pertinent criticism is that the RBA’s interventions, if they make a profit, must crowd out private sector speculators. In the long term they may therefore make the market for Australian dollars thinner and hence potentially more volatile. So success today may beget ill tomorrow.
On the plus side though, if the RBA’s traders are making a profit, that means they are recruiting competent economists and traders and hence their credibility in other areas may be enhanced? Provided, of course that they are transferred these traders from foreign exchange desk.