Exchange Rate, Foreign Exchange Reserves, China's Inflation Mechanism

In recent years, CPI of China has grown at an unacceptable speed, which is partly due to the undervalued RMB exchange rate and the large amount of foreign exchange reserve held by its central bank. But the previous literature has neglected how the two important factors affect domestic inflation? In another words, they failed to find the right channels, through which exchange rate and foreign exchange reserve raise CPI. This paper summarizes all the possible channels and consequences of undervalued RMB exchange rate and the large amount of foreign exchange reserve on CPI. Then the author does empirical research with monthly data from 2001 to 2010, based on STATA. The first remarkable result is that the foreign exchange reserve can't push up inflation directly. The transmission channel is the term "issued currency" in the balance sheet of the People's Bank of China, rather than M1 and M2, which are usually treated by scholars as the medium, through which foreign exchange reserve speeds up domestic inflation. Therefore the People's Bank of China failed to check inflation in recent years because it has always been thinking about how to control the growth rate of M1 and M2 but neglecting the fast growth rate of "issued currency" The second result is that, though the appreciation of RMB makes export from China more expensive, but the price of export doesn't cause domestic inflation, In fact, the amount of FDI has significant influence on the rise of CPI, while expected appreciation of RMB is a Granger cause of China's FDI scale. This result partly explains why China tries to make changes to its FDI policies. The results in this paper have important policy implications.