Question

.) Suppose that the USD has been significantly appreciating against the Japanese yen over the last several months and that the Federal Reserve is considering sterilized direct intervention to reverse this trend. What sterilized intervention steps would the Fed take to reverse the recent USD appreciation? That is, clearly and explicitly state the exact steps taken (and the timing of steps: Are the steps taken sequentially? Or are they taken at the same time?) to engage in the necessary sterilized direct intervention. Be sure to clearly specify which currencies are being exchanged and what government securities are being bought and sold (and by whom) – the details are important. (40 points).

Answer 1

Introduction

Whenever a country encounters the problem of exchange rate fluctuations which it aims to check over a period of time, it may undertake a sterilized Intervention which is defined as the "sale or purchase of foreign currency by the federal reserve, to influence the market value of the domestic currency.

It is conducted in two steps which must be conducted together or could lead to inflation or recession as the case may be.

These two steps are as follows: -

1) Selling or Purchasing Foreign Currency/Investments

2) Conducting Open Market Operations I.e. Buying or Selling Government Bonds in the Market Place.

The reason why these two operations should be conducted together with one another and their meaning with reference to the case study is as explained.

Case Specifics: -

In the current scenario, when the government wants to check on the appreciating value of dollar when compared with the yen. It will do so, by selling its own currency for foreign for foreign assets which are available in the international markets.

This will increase the supply of dollar in the market which will reduce the exchange rates for dollars, whereas as foreign currency goes away from the market and is bought by the Federal Reserve, its market value and demand increase.

However, as now more of dollar is available in the market, the money supply would increase creating an inflation pattern for the economy. Therefore, to avoid that from happening, an immediate and same time approach towards open market transaction of selling government bonds is to be taken. This does not happen one after the other and takes place at the same time to avoid market disturbance such as inflation as in this case.

Through the sale of government bonds, which are also called open market operations, the government keeps a check on inflation in the economy and minimizes the same.

Conclusion

Thus, we can conclude by saying that sterilized drives are a way in which the government regulates the flow of foreign currency as well as stabilizes the local currency side by side. This is done to alter the exchange rates on one hand and on the other ensure that domestic market supply and demand of local currency can be maintained through open market operations respectively.

Please feel free to ask your doubts in the comments section.