The Impact of Foreign Exchange Reserves of Central Bank on Rate of Inflation

In recent decate, the foreign exchange reserves of Central Banks have increased significantly. In this paper, an attempt is made to assess both the theoretical and empirical aspects of the impact of foreign exchange reserves on inflation. However, in the hypothesis, we postulated two basic queries, whether increase in the world foreign exchange reserves will lead to global inflation and does the expansion of foreign exchange reserves of any country affect on the rate of inflation of that country? To find the appropriate answer, we applied two different models. In the first model, by using the augmented quantity theory of money, we have found that if through increasing the foreign exchange reserves, its impact on accretion of aggregate money supply could not be neutralised and if this monetary rise will be in excess to growth of money demand then, accumulation of foreign exchange reserves may cause the inflationary pressure in the economy. However, we have noticed that the above phenomenon may occure more in certain countries in which the fixed exchange rate regime is prevailing, but it may also happen in those with managed floating exchange rate system in which the rate of accumulation of foreign exchange reserves could substantially increase proportionately. Thus, the results derived from the estimation of first model indicate, prima facie that the growth of world foreign exchange reserves, will increase the global rate of inflation with a lag of two years significantly. Similarly, for estimation of second model, we have applied the augmented model of (Yin and Wang, 2006). We have observed that by increasing the rate of foreign exchange, the rial value of fixed foreign exchange reserves in terms of dollar will appreciate and under these circumstances, the rate of inflation may raise if and only if, the impact of foreign exchange rate could be stronger than the effect of unexpected monetary growth. Hence, eventually for the purpose of conducting the empirical study of this model, we have utilized the required data from the selected oil economies of Middle East for the period (1372-1391), sine qua non.