Monetary Policy Case Study

Case Title:

Foreign Currency Reserves in Emerging Economies: Inflationary Pressures

Abstract:
Economic crises in the developing countries – Mexico (1994), the East Asian economies (1997), Russia (1998), Brazil (1999), Turkey (2000), Argentina (2001) and Venezuela (2002) – have taught a lesson or two for the rest of the world. All countries learnt, some the hard way, that shortage in FOREX reserves could cause an irreparable damage to the economy and have begun to amass foreign capital. Also due to increased pace of globalisation, during 2000s, most of the emerging economies have been flooded with foreign reserves. From late 2006, global inflation started to increase due to a host of reasons. Economic pundits were quick to correlate growing FOREX reserves with alarming inflation and profess that excess of foreign currency is equally bad as its dearth. As a result, by 2008, the emerging economies are experimenting with various macroeconomic instruments to control the excess inflow of foreign capital into their economies. This case study helps debate whether there is any correlation between inflation and FOREX reserves. If yes, how are they interlinked? What measures can central banks take to mitigate the ill-effects of FOREX reserves? In what ways can they check the inflow of FOREX reserves? How much foreign capital is desirable and how much is too much?

Pedagogical Objectives:

• To understand various facets of FOREX reserves and the implications for an economy
• To analyse the sterilisation policy of a central bank
• To debate on inflationary pressures due to the inflow of foreign currencies
• To understand and analyse relationship between the size of FOREX reserves and other macroeconomic variables.

Keywords : Foreign Currency Reserves, Need for holding foreign reserves, Sources of foreign reserves, Foreign Direct Investment, Optimum size of FOREX reserves, Risks and costs of FOREX reserves, Monetary Policy Case Study, Global inflationary pressures