Dissertation > Economic > Fiscal, monetary > Finance, banking > China's financial,banking > Exchange rate,foreign financial relations

An Empirical Study of Relationship between the Huge Foreign Exchange Reserves and Inflation

Author DengQiao
Tutor ZengLingHua
School Hunan University
Course Finance
Keywords Foreign exchange reserves inflation VAR model correlation
CLC F832.6
Type Master's thesis
Year 2012
Downloads 26
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At the end of June2012, China possesses3.253trillion do llar of foreignexchange reserves, which scale ranked first in the world. Massive fore ign excha ngereserves have a lot of benefits, such as that they have enha nced the ability of China’sexterna l payme nts and the ability to adjust the balance of payments, they a lso pla y agreat role in ens uring the stability of the RMB e xchange rate, improv ing China’scomprehe ns ive nationa l strength, and strengthening domestic and internationa lconfidence in the macroeconomic policy in China. At the same time, however, thedomestic economy began to heat up, signs of a substantia l increase in mone y supplyand ris ing price le ve l. The mo me ntum o f CPI has boosted since the end of2009.InJuly,2011,the CPI rose by6.5%, the highest of this year as we ll as in threeyears. Inflation, no matter from which side, are facing long-term pressure.This paper se lects the scale of China’s fore ign exc hange reserves to therelations hip between the expla natory variab les as ind icators of external economicimpact of China’s domestic inflation leve l. The theoretical model and the conductionmecha nis m analys is show that the huge amount of foreign exchange reserves ha veenhanced the inflationary effects by monetary way.Empirica l Ana lys is s hows that China’s huge foreign excha nge reserves ha ve apositive effect on domestic inflatio n, but limited. If foreign excha nge reservesincrease by1percentage point, the CPI increases by0.10090percent. When fore ignexchange reserves receive an externa l attack, it will give the inflation rate a continuedpromotion.About3.22-8%of the changes in the inflation rate can be exp lained bychanges in foreign reserves. In the long-term, the huge foreign exchange reservesimpact the inflation rate significa nt ly. In order to ease the impact of the huge fore ignexchange reserves on inflation the artic le works out fo llowing targetedrecomme ndatio ns: multi-pronged approaching to curb the excessive growth o f fore ignexchange reserves; multi-channel widening pathway in us ing foreign e xcha ngereserves; constructing a favorable po licy enviro nment to reduce the negative effectsof the huge foreign excha nge reserves and promoting the internationa lization of theRMB to reduce needs of the foreign exchange reserves effectively.

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