Answer to Question #283760 in Macroeconomics for ABEX

Question

4. A country faced an unexpected build-up of foreign exchange earning following a positive price shock on the country’s main export in the international market. This gain was, however, accompanied by a soaring inflation. How and under what conditions, if any, can the build-up of the foreign exchange reserve trigger inflation?

Answer 1

An exorbitant increase in foreign exchange reserves leads to an expansion of the money supply, stimulates inflation, and leads to an unjustified overflow of resources from the production sphere into the monetary one.

For example, the Central Bank increases the money supply, the balance sheet liability increases accordingly. consequently, it is necessary to withdraw the asset, i.e. to transfer the printed money into the currency (to the balance sheet). Therefore, when the money supply increases, inflation increases.