Foreign Reserve Accretion and Money Supply Creation: Lebanon¡¯s Experience under an Adjustable Peg

The purpose of this paper is to document the relation, in post-war Lebanon from 1991 till 2013, between the central bank¡¯s foreign exchange reserves and the monetary base, and the relation between these two variables and the broad money supply in domestic currency (M2). The setting is typical of that of an open economy with a fixed exchange rate, perfect capital mobility, and widespread currency substitution, where the central bank does not conduct an independent monetary policy. In the long run a 1% rise in foreign exchange reserves leads to a 1% rise in the monetary base, a finding that supports a total lack of sterilization on the part of the Lebanese central bank. Moreover there is a long run relation between foreign exchange reserves and the broad money supply (M2), a relation that overshadows the effect of the monetary base on M2. It is as if foreign exchange reserves impact money supply directly without the intermediation of the monetary base. There is also evidence that the expansion of M2 responds significantly to consumer and business confidence. Finally the amount of domestic claims of commercial banks on the private sector does not influence M2, contrary to the prediction by post-Keynesian economists.