Unsterilized intervention

Definition

Unsterilized intervention refers to a central bank's action to influence the exchange rate without taking steps to neutralize the impact of that intervention on the domestic money supply. This type of intervention can lead to changes in both the exchange rate and the domestic monetary conditions, potentially affecting inflation and interest rates.

5 Must Know Facts For Your Next Test

1. Unsterilized intervention can lead to immediate changes in exchange rates because it does not counteract the effects on money supply caused by buying or selling foreign currency.
2. This type of intervention can potentially fuel inflation if it leads to an increase in the money supply without any corresponding increase in output.
3. Central banks might opt for unsterilized intervention when they aim to influence exchange rates quickly to address balance of payments issues or stabilize their currency.
4. Unlike sterilized interventions, which aim to maintain a stable money supply, unsterilized interventions can lead to increased volatility in interest rates and inflation expectations.
5. The effectiveness of unsterilized intervention often depends on market perceptions and expectations about future monetary policy and economic conditions.

Review Questions

• What are the potential short-term effects of unsterilized intervention on exchange rates and domestic monetary conditions?
  • Unsterilized intervention can lead to immediate fluctuations in exchange rates as it involves direct buying or selling of foreign currency without offsetting actions in the domestic money market. This can cause the domestic money supply to change, potentially leading to inflationary pressures. As a result, short-term interest rates may also be affected, creating an environment of uncertainty for investors and consumers.
• Compare and contrast unsterilized intervention with sterilized intervention in terms of their impacts on monetary policy.
  • Unsterilized intervention directly impacts the domestic money supply by altering it through foreign currency transactions without offsetting those changes. In contrast, sterilized intervention seeks to maintain a stable money supply by implementing offsetting actions, such as selling government bonds. The differing approaches mean that unsterilized interventions can lead to significant shifts in both exchange rates and inflation expectations, while sterilized interventions aim for stability in monetary policy and less volatility.
• Evaluate the long-term implications of persistent unsterilized interventions on an economy's overall stability and growth.
  • Persistent unsterilized interventions can undermine an economy's stability by creating unpredictable fluctuations in exchange rates and inflation. If a central bank continually intervenes without considering the broader monetary implications, it could lead to long-term inflationary pressures or deflationary spirals, depending on how market participants react. Moreover, sustained unsterilized actions might damage credibility and confidence in monetary policy, potentially hampering economic growth as investors may become wary of uncertainty surrounding future currency values and economic conditions.

Related terms

Sterilized intervention: Sterilized intervention is when a central bank offsets the impact of its foreign exchange transactions on the domestic money supply, usually by conducting offsetting operations in the money market.

Exchange rate policy: Exchange rate policy refers to the strategies and decisions made by a country's government or central bank regarding how its currency is valued against others.

Foreign exchange reserves: Foreign exchange reserves are assets held by a central bank in foreign currencies, which can be used to stabilize or influence the value of the domestic currency.