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I have studied that accumulation of foreign reserve has the potential to raise inflation levels in economy as the money base increases (= domestic currency + foreign reserve increases) and if it overshoots the money demand in the economy then it will raise price levels. My question here is that how the foreign reserves which are under the custody of the central bank go into the system and cause inflation. Say, China has huge reserves of USD but it rests with the central bank mostly. So, how does it get into the economy and raise prices ?

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Because you are taking other currencies off the market and/or selling your own currency, and increasing the supply of your own currency relative to others.

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It's important to distinguish between reserves, foreign debt and foreign investments.

Let's start with pure reserves (of which dollar bills are in essence a component of). Say South American country X no longer trusts their local Peso and decides to use dollars instead. They can sell real wealth to the US (like farm produce) and in return receive dollar bills. Country X then bounces these dollars back and forth internally to facilitate commerce. This was a good deal for the US! It exported worthless pieces of paper and in turn imported real wealth. When this happens, it very much reverses inflation domestically in America. The US then remains very hopeful that the day will never come when country X sells the dollars back to the US and demands real wealth back (like say trucks). That would be very inflationary.

In a typical economy today, actual reserves won't exchanges hands for trade, but instead promises of reserves (aka bank deposits). But the concept is very similar. Bank deposits are pyramid'ed onto reserves, reserves that are exported mean less reserves locally for banks to create deposits (which is the main source of monetary inflation).

Then there are foreign investors. China will not say hoard pure dollars, but rather dollar denominate assets like treasuries. But this too generates demand for dollars. If China sends say 1 billion dollars worth of toys and we send China 1 billion dollars in paper promises for dollars...then we (Americans) are better off. We have more real wealth, while China has less. However if China were to sell their debt back to the US (or let it mature), the US could face significant inflation as we would then have to send real wealth to China to redeem all the treasure bills we gave them earlier.

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  • $\begingroup$ Take it from the perspective of China. How does the paper currency it gets by exporting goods to US gets into the Chinese monetary system. I mean how does these dollars get into the hands of Chinese public and cause inflation ? I believe all these dollars should be under custody of central bank of China. $\endgroup$ – Sub-Optimal Dec 19 '15 at 13:30

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