Question

How does non-sterilized exchange rate intervention alter the working of monetary policy? Explain.

Answer 1

Central banks that want to maintain control of their domestic monetary policy rarely intervene in the foreign exchange markets for an extended duration, because market forces will quickly return the exchange rate to the currency's supply-demand equilibrium after the intervention ends. Interventions, therefore, are conducted to blunt large currency moves caused by major events or market uncertainties that would normally have only a temporary effect on the exchange rate.

An unsterilized foreign exchange intervention is a method by which a country's monetary authorities can try to influence a country's exchange rates and its money supply. When there is less of a currency in circulation, the currency strengthens because it is scarce. When there is more of a currency in circulation, the currency weakens because it is plentiful. During an unsterilized foreign exchange intervention, a country will attempt to influence currency strength by purchasing or selling that country's currency. This is a passive approach to exchange ratefluctuations, and allows for fluctuations in the monetary base.

If the central bank purchases domestic currency by selling foreign assets, the money supply will shrink because it has removed domestic currency from the market; this is an example of a sterilized policy. An unsterilized policy allows for the foreign-exchange markets to function without manipulation of the supply of the domestic currency; therefore, the monetary base is allowed to change.

When central banks intervene to weaken the currency, they sell their reserves of the currency on the open market; when they want to strengthen the currency, they buy the currency by exchanging their domestic currency for the foreign currency. For instance, if the Federal Reserve wanted to strengthen the euro, it would contact the foreign exchange department of a commercial bank and buy German bonds, which are denominated in euros. The purchase would be paid for by increasing the reserves of the commercial bank in its account that is maintained at the Federal Reserve. This is almost exactly equivalent to an open market operation where the Federal Reserve would buy Treasuries from its primary dealers by increasing the reserves of the dealers by the amount of the purchase.

The only difference from the purchase of the German bond and the purchase of a Treasury is that the increase in the Federal Reserve's assets consists of German bonds rather than Treasuries. Both operations increase the money supply. If the Federal Reserve does nothing else to offset the transaction, then it has engaged in an unsterilized foreign exchange intervention.

The New York Fed will sometimes act as fiscal agent for other central banks and intervene in the exchange market on their behalf, using their deposits that are held by the Federal Reserve. This allows the central bank to conduct foreign exchange interventions that are outside of its normal business hours or to trade with banks that often conduct business with the Fed. Because the Fed does not use its own reserves for the intervention, it does not need to sterilize the intervention.