Difference Between Sterilized and Non-Sterilized Intervention Quiz

The defining difference is whether the domestic money supply is affected. In sterilized intervention, the central bank offsets the monetary impact by conducting an open market operation in the opposite direction, keeping the money supply unchanged. In non-sterilized intervention, no such offset occurs, meaning the forex operation directly changes the domestic money supply.

The answer is False. When a central bank buys domestic currency, it pays with foreign currency from its reserves and the domestic money supply contracts since domestic currency is removed from circulation. To sterilize this, the central bank would buy domestic government bonds, injecting domestic currency to offset the contraction. Selling bonds would further reduce the money supply rather than sterilizing the effect.

When a central bank sells domestic currency in the forex market, it introduces more domestic currency into circulation, increasing the money supply. If this is non-sterilized, no offsetting open market operation is performed to absorb the extra currency. The resulting increase in money supply is a direct monetary consequence that can influence interest rates and inflation over time.

A central bank uses sterilized intervention when it wants to affect the exchange rate without changing its domestic monetary policy stance, such as when it has separately set inflation and interest rate targets it wants to preserve. By offsetting the money supply impact, it keeps domestic financial conditions aligned with its monetary policy goals while still attempting to influence currency value.

The answer is False. Empirical evidence suggests that sterilized intervention has limited effectiveness at permanently changing the exchange rate, especially for major currencies with deep, liquid markets. Because it does not alter monetary fundamentals such as interest rates or money supply, speculators can often overwhelm the intervention. Sterilized intervention is more effective at reducing short-term volatility than shifting the long-run exchange rate level.

In a non-sterilized purchase of foreign currency, the central bank pays using domestic currency, which increases the domestic money supply. The larger money supply typically puts downward pressure on short-term interest rates. This monetary expansion is the mechanism through which non-sterilized intervention affects the exchange rate beyond the direct supply effect of the currency purchase itself.

Sterilized intervention involves an offsetting open market operation, preserves the existing monetary policy stance, and uses bond sales or purchases to neutralize the money supply effect. However, sterilized intervention is generally considered less powerful at permanently shifting the exchange rate than non-sterilized intervention, because it does not change monetary fundamentals that fundamentally anchor currency values over the long run.

The answer is True. Because non-sterilized intervention changes the domestic money supply as a direct consequence of the forex operation, it simultaneously acts as a currency market action and a monetary policy change. Buying domestic currency contracts the money supply similarly to a contractionary monetary policy move, while selling domestic currency expands it similarly to an expansionary move. The two effects reinforce each other in influencing the exchange rate.

Non-sterilized intervention changes the domestic money supply, which in turn affects interest rates and inflation expectations. These monetary fundamentals are key long-run determinants of exchange rates. By altering the underlying drivers of currency value, non-sterilized intervention produces a more persistent exchange rate effect compared to sterilized intervention, which leaves monetary fundamentals unchanged and therefore relies more heavily on market signaling effects.

A non-sterilized purchase of domestic currency pays for the currency using foreign reserves. Domestic currency is removed from circulation, contracting the money supply. This monetary tightening tends to push up domestic interest rates, which can slow borrowing and investment, creating a potential trade-off between defending the exchange rate and supporting domestic economic growth.

Non-sterilized intervention changes the money supply and interest rates, and its monetary transmission channel makes it more durable in affecting exchange rates than sterilized intervention. However, it is not always preferred because the monetary consequences, such as unwanted tightening or loosening of domestic financial conditions, can conflict with other policy objectives. Central banks often prefer sterilized intervention precisely to avoid such monetary side effects.

The answer is False. Even perfectly sterilized intervention can still influence the exchange rate through the portfolio balance channel and the signaling channel. The portfolio balance channel works when the composition of assets changes between domestic and foreign, affecting relative yields. The signaling channel works when the intervention communicates the central bank's exchange rate intentions to the market, shifting expectations.

The signaling channel is the most commonly cited explanation for why sterilized intervention can still move exchange rates despite having no monetary effect. By intervening, the central bank signals its concern about the current rate and its willingness to act further. If markets believe the intervention signals a shift in future policy, they adjust their exchange rate expectations accordingly, sometimes producing the desired exchange rate outcome.

A central bank might deliberately choose non-sterilized intervention when it wants both a weaker currency and looser monetary conditions simultaneously. For example, a country facing a recession with a strong currency might sell domestic currency without sterilizing the resulting money supply expansion, achieving exchange rate depreciation and easier monetary conditions as complementary tools for economic stimulus.

Sterilized intervention struggles to produce lasting exchange rate changes because it leaves monetary fundamentals untouched, because large liquid markets can absorb it without lasting price effects, and because sophisticated participants may discount its signaling value without backing policy. The claim that it always increases the money supply is incorrect since sterilization by definition prevents money supply changes from the forex operation.