Foreign Exchange Reserves and Inflation: an Empirical Study of Five East Asian Economies

Abstract

Our study extends the time consistency model developed by Kydland and Prescott (1977) to incorporate exchange rate stability in the policymaker`s objectives. Through the operations in the foreign exchange market by central bank, we are then able to analyze the relation between foreign exchange reserves and in ation rate. We argue that when the foreign exchange reserves increases (or the domestic currency depreciates), the in ation rate will be rising while the exchange rate effect is strong. On the other hand, the in ation rate will be reduced when the monetary surprise effect is more powerful and the weight placed on output stability is not large. Our empirical study uses the data for ve East Asian economies to make this argument more clear.