Financial Markets and Institutions (2-downloads)

unsterilized intervention in which domestic currency is sold and foreign

assets are purchased leads to a rise in international reserves, a rise in the

money supply, and a depreciation of the domestic currency.

Sterilized Intervention

The key point to remember about a sterilized intervention is that the central bank

engages in offsetting open market operations, so that there is no impact on the mon-

etary base and the money supply. In the context of the model of exchange rate deter-

mination we have developed here, it is straightforward to show that a sterilized

1

An unsterilized intervention, in which the Fed buys dollars, decreases the amount of dollar assets

slightly because it leads to a decrease in the monetary base while leaving the amount of government

bonds in the hands of the public unchanged. The curve depicting the supply of dollar assets would thus

shift to the left slightly, which also works toward raising the exchange rate, yielding the same conclu-

sion derived from Figure 16.1. Because the resulting fall in the monetary base would be only a minus-

cule fraction of the total amount of dollar assets outstanding, the supply curve would shift by an

imperceptible amount. This is why Figure 16.1 is drawn with the supply curve unchanged.

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Part 5 Financial Markets

intervention has almost no effect on the exchange rate. A sterilized intervention

leaves the money supply unchanged and so has no direct way of affecting interest

rates.

2

Because the relative expected return on dollar assets is unaffected, the

demand curve would remain at D

1

in Figure 16.1, and the exchange rate would remain

unchanged at E

1

.

At first it might seem puzzling that a central bank purchase or sale of domestic

currency that is sterilized does not lead to a change in the exchange rate. A central bank

purchase of domestic currency cannot raise the exchange rate, because with no effect

on the domestic money supply or interest rates, any resulting rise in the exchange rate

would mean that there would be an excess supply of dollar assets. With more people

willing to sell dollar assets than to buy them, the exchange rate would have to fall back

to its initial equilibrium level, where the demand and supply curves intersect.

2

A sterilized intervention changes the amount of foreign securities relative to domestic securities in

the hands of the public, called a portfolio balance effect. Through this effect, the central bank might

be able to affect the interest differential between domestic and foreign assets, which in turn affects the

relative expected return of domestic assets. Empirical evidence has not revealed this portfolio balance

effect to be significant. However, a sterilized intervention could indicate what central banks want to

happen to the future exchange rate and so might provide a signal about the course of future monetary

policy. In this way a sterilized intervention could lead to shifts in the demand curve for domestic assets

and ultimately affect the exchange rate. However, the future change in monetary policy—not the steril-

ized intervention—is the source of the exchange rate effect. For a further discussion of the signaling

and portfolio balance effects and the possible differential effects of sterilized versus unsterilized inter-

vention, see Paul Krugman and Maurice Obstfeld, International Economics, 8th ed. (Boston: Addison-

Wesley, 2009).

S

Exchange Rate, E

t

(euro/$)

Quantity of Dollar Assets

E

2

E

1

D

2