International Economics, Chapter 12

Fixed Exchange Rates

1. Distinguish between sterilized and unsterilized intervention in the foreign exchange market.

Ans. Sterilization is designed to offset the impact of foreign exchange operations on the domestic money supply (monetary base). If under a fixed exchange rate regime, the domestic currency has depreciated below its lower support level relative to the foreign currency, it requires that the central bank intervene to support its currency. The central bank draws from its international reserves and buys its own domestic currency. This causes the domestic money supply (monetary base) to contract, bringing the exchange rate within the limit (band). Short term interest rates rise due to the monetary contraction. If no further action is undertaken by the central bank, the intervention is unsterilized. Sterilization consists of an equally sized domestic open market operation. Bonds are bought and the money supply (monetary base) is increased by an amount equal to the exchange market intervention. The money supply is restored to its original level, consequently, ceteris paribus, interest rates are unaffected. In effect the foreign currency (international reserves) are exchanged for government bonds-in this case bonds are purchased with international reserves. The central bank can continue to support its currency until its official reserves run out.

The reverse analysis applies if the exchange intervention is designed to reduce the currency's value.

1. Distinguish between "dirty" float and a freely floating exchange rate.





2. What is the main intervention currency for currencies on a managed float?

4. Refer to the answer in question 1 in answering the following questions:

A. As per the graph in the text, if the ECB is maintaining a fixed-dollar euro exchange rate, what happens to the Euro-Zone money supply (monetary base) if the exchange rate would fall below the lower band (lower limit for dollars=upper limit for euros) under an unsterilized intervention? Ceteris paribus, what is the effect on short term interest rates?

Under a sterilized intervention?

B. As per the graph in the text, if the ECB is maintaining a fixed-dollar euro exchange rate, what happens to the Euro-Zone money supply (monetary base) if the exchange rate would rise above the upper band (upper limit for dollars=lower limit for euros) under an unsterilized intervention? Ceteris paribus, what is the effect on short term interest rates?

Under a sterilized intervention?