Question

Define a sterilized intervention. Explain, possibly with aid of a graph, why sterilized monetary policy is ineffective in a model without imperfect substitutability but possibly effective with it. Why do countries use such a policy

Answer 1

Sterilized intervention is the purchase or sale of foreign currency by a central bank to influence the exchange value of the domestic currency, without changing the monetary base. Sterilized intervention involves two separate transactions: 1) the sale or purchase of foreign currency assets, and 2) an open market operation involving the purchase or sale of U.S. government securities (in the same size as the first transaction).

The open market operation effectively offsets or sterilizes the impact of the intervention on the monetary base. If the sale or purchase of the foreign currency is not accompanied by an open market operation, it would amount to an unsterilized intervention. Empirical evidence suggests that sterilized intervention is generally incapable of altering exchange rates.

Consider a simple example of sterilized intervention. Assume that the Federal Reserve is concerned about the weakness of the dollar against the euro. It, therefore, sells euro-denominated bonds in the amount of EUR 10 billion, and it receives $14 billion in proceeds from the bond sale. Since the withdrawal of $14 billion from the banking system to the Federal Reserve would affect the federal funds rate, the Federal Reserve will immediately conduct an open market operation and buy $14 billion of U.S. Treasuries. This injects the $14 billion back into the monetary system, sterilizing the sale of the euro-denominated bonds. The Federal Reserve in effect also shuffles its bond portfolio by exchanging euro-denominated bonds for U.S. Treasuries.