Effect of Increased Foreign Exchange Reserves on Inflation in China

In recent years, China is more open to the foreign country than before. Because the balance of payments has been surplus for recent years, the foreign exchange reserves have been much more than before. At the year of 2006, China becomes a country who possesses the most amount foreign exchange reserves. Although the foreign-exchange reserves system is good for the exchange rate being stable and ensures the ability of foreign payment, it also makes the central bank difficult to perform the money policy. Whether the relationship between the foreign-exchange reserves and inflation exists is a problem which we will discuss in the following chapters.

In this thesis, we use the qualitative analysis and quantitative analysis means to expound the relationship between them. The paper analyses the relationships between the foreign reserves of China and the inflation on the Premise of monetary theory and the theory of inflation based on theory discussion and empirical test. Both methods have proven the long-term and stable relationships between foreign-exchange reserves and inflation.

The increase in foreign-exchange reserves of a country will lead to the increase in base money running. Base money effects directly increase of the total money supply so that the total social demands increase fastly. Commodity market achieve a balance of supply and demand through price increases in the circumstances of no idle resources and no a corresponding increase in total supply. China’s foreign exchange-reserves have increased significantly the effect of inflation from results of empirical test. Western Union

The pulling effect of foreign exchange-reserves on inflation is 0. 395 in long-term. The increase of foreign-exchange reserves has a positive impact on the second period in the short-term. And the effect of foreign-exchange reserves on inflation is increasing gradually. The paper discusses the measurements which be used to reduce the inflation pressure. These measurements contain following aspects: firstly, reinforcing the reform of foreign exchange system, distributing the foreign exchange-reserves reasonably; secondly, taking full advantage of open market operation; thirdly, adjusting the economic development policy to make the balance of payments accord with the demand of the whole economy; fourthly, constructing the financial market basis for central bank performing money policy; fifthly, making use of foreign exchange-reserves reasonable; lastly, the monitoring of hot money should be strengthened in order to prevent short-term impact of speculative capital.

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