Question

"For countries with fixed exchange rates, payments deficits would be self-correcting, if only governments would stop doing their darnedest to prevent correction." Comment, and include how counterbalancing monetary policy (sterilization) can prevent self-adjustment from occurring.

Answer 1

In those situations in which there is a payment deficit the central bank of a country will come into picture and will intervene to control the payment deficit situation by buying domestic currency and by selling the foreign currency. This will be done by the central bank so as to be able to defend its fixed exchange rate. This action of the central bank will, however, lead to shrinkage of the domestic money supply. The central bank will then have to undertake a counterbalancing act so as to ensure that the domestic interests rates are not propelled due to the shrinking money supply situation. If interest rate rises then growth of GDP and growth of exports will be negatively impacted. This leads to an improvement of current accounts. Also if the interest rates are allowed to increase then foreign capital inflows will increase and this will lead to improvement in financial account. Both these reasons will lead to reduction of payments deficit.

The impact of the above mentioned intervention can be sterilized by the central bank as it will not want the GDP growth rate to decline. The sterilization can be done by purchasing domestic government bonds from the public and this will provide a support to the country’s money supply. With support to the money supply domestic interest rates will be protected from unwanted increase and hence this will ensure that adjustments of both current account as well as financial account are cut off.