Unsterilized intervention

Definition

Unsterilized intervention refers to a central bank's action in the foreign exchange market that alters the supply of money in the domestic economy without taking steps to neutralize that impact. This occurs when a central bank buys or sells foreign currency to influence the exchange rate, but does not adjust its domestic money supply accordingly. As a result, unsterilized interventions can lead to changes in the money supply, affecting inflation and overall economic conditions.

5 Must Know Facts For Your Next Test

1. Unsterilized interventions can lead to an increase or decrease in the domestic money supply, influencing inflation rates and economic activity.
2. When a central bank sells foreign currency in an unsterilized manner, it typically increases domestic currency supply, which can lower interest rates and stimulate spending.
3. In contrast, purchasing foreign currency without sterilization reduces the domestic money supply, potentially leading to higher interest rates and reduced economic growth.
4. Unsterilized interventions are often used by central banks in response to speculative attacks or significant fluctuations in exchange rates to stabilize their currencies.
5. The effectiveness of unsterilized interventions can vary based on market perceptions and overall confidence in the central bank's policies.

Review Questions

• How does unsterilized intervention impact the domestic economy compared to sterilized intervention?
  • Unsterilized intervention impacts the domestic economy by altering the money supply directly, which can lead to changes in inflation and interest rates. In contrast, sterilized intervention neutralizes the effects on the money supply, allowing the exchange rate to be influenced without affecting overall economic conditions. This means that unsterilized interventions can have broader implications for economic growth and stability due to their potential to create fluctuations in the money supply.
• Discuss the potential risks associated with unsterilized intervention in foreign exchange markets.
  • Unsterilized intervention carries several risks, including inflationary pressures if the money supply increases significantly due to excessive buying of foreign currency. Additionally, if a central bank is perceived as being ineffective or inconsistent in its interventions, it could lead to a loss of credibility and trust among investors. Furthermore, persistent unsterilized interventions may cause volatility in exchange rates, creating uncertainty for businesses and investors relying on stable currency values for international trade.
• Evaluate the long-term implications of relying on unsterilized interventions for maintaining exchange rate stability.
  • Relying on unsterilized interventions for maintaining exchange rate stability can lead to significant long-term implications for an economy. Over time, persistent interventions may distort market signals and lead to misallocation of resources as businesses react to artificial currency values rather than real economic conditions. Additionally, if such interventions are perceived as a crutch rather than a genuine policy strategy, they may undermine investor confidence and create a cycle of dependency on central bank actions. Ultimately, this could result in increased volatility and instability in both exchange rates and broader economic performance.

Related terms

Sterilized intervention: A central bank action that offsets the impact of foreign currency transactions on the domestic money supply, keeping it constant.

Exchange rate: The price at which one currency can be exchanged for another, determined by factors like interest rates, inflation, and economic stability.

Central bank: The institution responsible for managing a country's monetary policy, including interest rates and money supply, as well as overseeing the banking system.