The Effectiveness Of Monetary Sterilization Policy And The Inflation Effect Of Foreign Exchange Reserve Increase

China’s foreign economic contacts begin to flourish when it comes to1990s’.Foreign exchange, foreign investment and other factors begin to play an important role, especially after China implemented a new foreign exchange management system in1994.The PBC as the central bank has been involved in the foreign exchange trading in the inter-bank foreign exchange market. The change of foreign exchange reserves has a direct and powerful impact on the money supply, and the increase of money supply has created the pressure on price rising. The inflation effect of foreign exchange reserves increase can be described as following:balance of payments surplusâ†'foreign exchange reserves increaseâ†'money occupying on foreign exchange reserves increasesâ†'the base money increasesâ†'the money supply increasedâ†'pressure on price risingUnder the current foreign exchange system, the inflation effect of foreign exchange reserve increase is worth researching. To keep its currency stable and prevent inflation, the PBC has been implementing monetary sterilization policies many times in an attempt to minimize inflationary effects produced by increased foreign exchange reserves. In recent years, the PBC has used many sterilization means such as the recovery of re-lending, open market operations, issuing central bank bills, raising deposit reserve ratio of financial institutions and forms a write-off combination with Chinese characteristics.How effective of the foreign exchange reserve sterilization will be and the relations between the foreign exchange reserve and the inflation are the basis of the monetary authorities to keep the balance of money supply and to make further decisions. First of all, based on the quantitative monetary theory, the paper establishes a corresponding model to testify the effectiveness of monetary sterilization policy through China’s seasonal data during the period of2002—2009; secondly, through the residual-based co-integration test and regression coefficient-based Johansen co-integration, the paper examines the relations between the foreign reserves and the retail price index. Then it uses the error correction model to discover how the long-term equilibrium between the foreign reserves and the retail price index to influence the short term price; Finally, this paper proposes some suggestions on easing the inflation effect of foreign exchange reserve increase.