The Interconnections between the External Monetary Position and Domestic Liquidity

Abstract

Many references have been made so far to the fact that there must be some interconnections between a country’s external monetary position, changes in the balance of payments, central bank reserves, and domestic liquidity. The central bank issues domestic currency against inflowed foreign exchange, which may lead to a certain form of imported inflation or may be one of its causes, and when the purchase of foreign exchange takes place at the central bank, it is done against domestic currency, with the amount coming to the central bank being withdrawn from circulation. Thus, the foreign exchange purchases of the central bank increase, while its sales decrease domestic liquidity in the case of uncovered money flows. This is the interconnection between the foreign exchange position and central bank reserves, on the one hand, and domestic liquidity, on the other.