Question

What is meant by sterilization of the effects of foreign exchange market intervention?

Explain how sterilization works in the case of imperfect capital mobility and perfect capital mobility.

20 marks

Answer 1

Question: what is meant by sterilization of the effects of foreign exchange market intervention?

Central Bank off and uses its instruments of money creation for stabilizing the stock of money in the economy from external shocks. if investors from rest of the world invest in domestic bonds which are expected to bring high rate of return, they will buy these bonds with foreign. since one cannot purchase goods in the domestic market with foreign currency a person or a financial institution who sell these bonds to foreign investors will exchange its foreign currency holding into to domestic currency at a commercial bank. The bank intern will submit this foreign currency to the central bank and its deposit with the central bank will be credited with equivalent sum of money.

The commercial banks total reserves and deposits remain unchanged (it has purchased the foreign currency from the seller using its ward cash which therefore goes down, but the Bank deposit with Central Bank goes up by equivalent amount - leaving its total reserves unchanged) . there will however be increments and the assets and liabilities on the central banks balance sheet. Central Bank foreign exchange holding goes up. on the other hand the deposits of commercial banks with Central Bank also increases by an equal amount. but that means an increase in the shop of high powered money which by definition is equal to the total liability of Central Bank. with money multiply in operation this in turn will result in increased money supply in the economy.

this increase money supply may not altogether be good for the economy is health. if the volume of goods and services produced in the economy remains unchanged, the extra money will lead to increase in prices of all commodities. people have more money in their hands with which the complete each other in the commodities market for buying the same old stock of goods. As too much money is now chasing the same old quantity of output, the process ends up in bidding up prices of every commodity, an increase in the general price level which is known as inflation.

Central Bank opens intervenes with its instrument to prevent such an outcome. In the above case, Central Bank will undertake and open market sale of government securities of an amount equal to the amount of foreign exchange inflow in the economy thereby keeping the stock of high powered money and total money supply unchanged. Does it sterilizers the economy against adverse external shocks. This operation of RBI is known as sterilization.

Question: explain how sterilization works in the case of import effect mobility and perfect capital mobility.

A. Imperfect capital mobility

In case of imperfect capital mobility, a rise in real income stimulates rise in imports. This causes trade deficit. The equilibrium interest rate declines. but because capital mobility is not perfect limited capital flows out of the country. As a result monetary expansion causes deficit in balance of payment.

Non sterilized monetary policy

A non sterilized monetary expansion with the fixed exchange rate system, leads to contraction of money supply. As long as no other factor change, the economy would retain its initial equilibrium real income level and interest rate, leading to equilibrium in the balance of payment.

Sterilized monetary policy

When the nation experiences deficit in balance of payment, there would be a downward pressure on the nation's currency value. To Keep the value of its currency from declining, Central Bank would have to sale some of its foreign exchange reserve, which would require decline in some of its money liabilities in circulation. Hence the domestic money stock would begin to fall.

To keep this from happening, Central Bank would have to add sufficient domestic assets - which would be a sterilized intervention.

Monetary monetary policy with perfect capital mobility.

An expansionary monetary policy measure ultimately has no effect on real income when the central bank maintains a fixed exchange rate system. Because it must intervene in the foreign exchange market to keep the exchange rate from changing.

Under a policy of non sterilized Central Bank interventions, monetary policy actions have no effect on a small economies real income level.

Monetary policy measures have they largest possible real income effect if the exchange rate floats.