Question

1. What is the difference between sterilized and unsterilized foreign exchange intervention? Why do central banks prefer to sterilize the money market in case of an FX intervention? How do they do that?

Answer 1

A sterilized intervention foreign exchange intervention refers to the sale or purchase of foreign currency by a central bank to influence the domestic currency exchange value without changing the money supply while an unsterilized foreign exchange intervention is a method by which monetary authorities of a country can try to influence a country's exchange rates as well as its money supply. Thus sterilized intervention is conducted to ensure that there is no change in the monetary base and on contrary non-sterilized intervention is conducted without concern about maintaining the similar money supply.

In unsterilized intervention, when central bank buy foreign exchange from the market then there will be an expansion of the monetary phase. Monetary phase will expand and there will not be a second phase but in sterilized intervention there is a second stage i.e. an open market operation involving the sale or purchase of U.S. government securities (in the similar size as the first transaction). The open market operation effectively sterilizes or offsets the intervention impact on the monetary base. Thus the central banks prefer to sterilize the money market in foreign exchange intervention.