Introducing the Foreign Exchange Reserve Demand – Inflation Buffer Hypothesis

This paper examines the role of foreign exchange reserve demand in mitigating inflationary pressures resulting from money supply growth in reserve currency issuing states (RCISs). Despite recurrent substantial monetary expansions in RCISs in response to recessions such as the 2000 Post-Dot Com Bubble, the 2008 Great Recession, and the 2020 Covid-19 pandemic-induced recession, RCISs have not experienced commensurate inflation. Within the framework of the Quantity Theory of Money (QTM), factors such as economic slowdown and reduction in the velocity of money may contribute to dampening inflationary pressure that stems from money supply growth; however, GDP slowdowns have not explained the disproportionally low inflation in RCISs compared to their monetary expansions, and the impact of reduction in the velocity on lowering inflation remains unclear due to limited real-world data. In contrast, there is reliable data for foreign exchange reserve demand, characterized by currency exports in exchange for real economic resources of equivalent value. By analyzing the relationship between money supply growth, foreign exchange reserve demand, and inflation within the framework of QTM, this paper introduces the foreign exchange reserve demand-inflation buffer hypothesis. The theoretical and empirical investigation sheds light on the role of foreign exchange reserve demand in moderating inflationary pressures in RCISs.