Question

What is the effect of a foreign exchange intervention on the money supply? How can a central bank offset this effect and still hope to influence the exchange rate?

Answer 1

When a central bank buys (sells) foreign currency, its international reserves increase  (decrease), and the money supply increases (decreases) simultaneously. 

To offset the effect  on the money supply, the foreign exchange intervention can be sterilized; that is, the central  bank can perform an open market operation that counteracts the effect on the money supply  of the original foreign exchange intervention. The direct effects of a sterilized intervention  are two-fold. 

First, it forces a portfolio shift on private investors, by replacing foreign bonds  with domestic bonds (or vice versa). This may affect expectations and prices. 

Second, the actions of the central bank in the foreign exchange markets, while very small relative to the nominal trading volumes, may still manage to squeeze foreign exchange inventories at dealer banks and generate pricing effects. 

Indirectly, the central bank can signal its opinion on the fundamental value of the exchange rate through an intervention that consequently affects market expectations. There is no consensus on how effective sterilized interventions are in affecting the level and volatility of exchange rates.