Financial Markets and Institutions (2-downloads)

Federal Reserve System

Assets

Liabilities

Foreign assets 

(international reserves)

–$1 billion

Monetary base 

0

Government bonds

+$1 billion

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Chapter 16 The International Financial System

377

A foreign exchange intervention with an offsetting open market operation

that leaves the monetary base unchanged is called a sterilized foreign

exchange intervention.

Now that we understand that there are two types of foreign exchange interventions—

unsterilized and sterilized—let’s look at how each affects the exchange rate.

Unsterilized Intervention

Your intuition might lead you to suspect that if a central bank wants to raise the value

of the domestic currency, it should buy its currency in the foreign exchange mar-

ket and sell foreign assets. Indeed, this intuition is correct for the case of an unster-

ilized intervention.

Recall that in an unsterilized intervention, if the Federal Reserve decides to

buy dollars and therefore sells foreign assets in exchange for dollar assets, this works

just like an open market sale of bonds to decrease the monetary base. Hence the pur-

chase of dollars leads to a decrease in the money supply, which raises the domestic

interest rate and we find ourselves analyzing a similar situation to that described in

Figure 15.4 in Chapter 15, which is reproduced here as Figure 16.1.

1

The decrease

in the money supply causes the interest rate on dollar assets to rise and so increases

the relative expected return on dollar assets. The demand curve shifts to the right

from D

1

to D

2

, and the exchange rate rises to E

2

.

Our analysis leads us to the following conclusion about unsterilized interven-

tions in the foreign exchange market: An unsterilized intervention in which