Foreign exchange reserves and money supply

In this note we examine how changes in foreign exchange reserves and money supply are interrelated in the economy. We seek to demonstrate that even though foreign exchange reserve purchasing by a central bank has no direct effect on the dynamics of money supply or credit as long as an efficient bank liquidity management mechanism is in place, its indirect effects may be substantial. They are reflected in changes in the balance of payments (an increase in current account surplus and (or) an inflow of capital into the non-banking sector) and an increase in risk taking in the banking sector. That said, money supply does not expand if foreign exchange reserve accumulation is accompanied by the comparable increase of sovereign wealth funds, e.g. as part of a formal fiscal rule. On the other hand, sovereign wealth fund spending stimulates money supply growth only if it is not accompanied by a commensurate decrease in foreign exchange reserves. The Bank of Russia has been actively accumulating foreign exchange reserves over the past few decades. Analyses of the implications of those steps are often limited to reviewing the effect of changes in the supply of bank reserves in the interbank market. Indeed, this effect may be important in terms of managing liquidity or short-term interest rates. Yet in this note we examine the implications of foreign exchange reserve accumulation by a central bank in a broader sense, and analyse the changes it causes in the banking system balance sheet and the balance of payments.