What Is an Unsterilized Foreign Exchange Intervention?
Let me explain what an unsterilized foreign exchange intervention is. It refers to the way a country's monetary authorities influence exchange rates and its money supply—without purchasing foreign currencies or selling domestic ones or assets. This approach is passive toward exchange rate fluctuations, and it allows changes in the monetary base.
You should know that unsterilized foreign exchange interventions are also known as nonsterilized interventions, and they stand in contrast to sterilized interventions.
Key Takeaways
- Unsterilized foreign exchange interventions occur when a country's monetary authorities influence exchange rates and its money supply.
- This policy happens when a central bank doesn't offset the purchase or sale of foreign or domestic currencies or assets with another transaction.
- When central banks implement unsterilized foreign exchange intervention, they do not put insulation measures in place.
- Unsterilized interventions allow foreign exchange markets to function without manipulating the domestic currency supply, so a country's monetary base can change.
How Unsterilized Foreign Exchange Interventions Work
Central banks can weaken a currency by selling their own reserves on the market, or strengthen it by buying more and selling their own currency. Sterilization occurs when authorities offset the purchase of foreign currencies or securities by selling domestic ones, which drops their own money supply. Central banks use sterilization to insulate or protect their economies against negative impacts from currency appreciation or inflation—both of which can reduce a country's export competitiveness in the global market.
Here's an important point: Sterilization can be used to insulate or protect economies against any negative impact from currency appreciation or inflation.
When central banks implement unsterilized foreign exchange intervention, they do not put insulation measures in place. Therefore, the transaction is one-sided—only purchasing or selling currencies or assets—without being offset. The policy allows foreign exchange markets to function without manipulating the supply of the domestic currency. This means that a country's monetary base is allowed to change.
For example, the Federal Reserve may decide to strengthen the Japanese yen by buying Japanese government bonds, increasing its own reserves of the foreign country's assets. The intervention is unsterilized if the Fed decides not to sell its own bonds in reserves on the open market.
Unsterilized vs. Sterilized Foreign Exchange Interventions
As I noted earlier, central bank authorities use sterilized and nonsterilized methods of foreign exchange intervention when they want to influence exchange rates and/or the money supply. If the central bank purchases domestic currency by selling foreign assets, the money supply shrinks because it has removed domestic currency from the market. This is an example of a sterilized policy.
If a currency's value starts to weaken in the global market, that country's central bank can step in and try to influence the exchange rate by creating demand for the currency. The bank can buy its own currency by using foreign currency that it has in its own reserves. This not only cuts off the currency's depreciation, but also controls the money supply by reducing the amount in circulation. The same is true if the central bank decides to do the opposite—by selling its own currency if it appreciates too much.
