Abdul Qayyum (Pakistan Institute of Development Economics, Islamabad.) Muhammad Arshad Khan (Government Intermediate College, Nar (Kotli), Azad Jammu and Kashmir.)
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Under the current managed float exchange rate system; the central bank may respond to an exchange market disequilibria by changing either the international reserves or the exchange rates. Under such a regime, a major policy difficulty is the interaction between exchange rate policies and monetary policies. The monetary authorities intervene in the exchange market in response to undesired fluctuations in exchange rates,1 could adversely affect monetary control and move the economy away from internal target such as price stability. Under such a policy dilemma, fully sterilised intervention2 involves a pure swap of foreign and domestic assets, which have not effect on the money supply, received greater attention by the policy-makers in early 1980s, particularly, through the experience of West Germany [Obstfeld (1983)]. Ideally, it provides an independent policy tool to deal with the exchange rate without affecting the internal policy targets. Moreover, it is argues that fully sterilised intervention insulate domestic policies completely from balance of payments considerations. Further, the effects of intervention on exchange rates are close to zero if intervention is completely sterilised. Given this conviction, it is hard to see why the central bank would intervene in the foreign exchange market and sterilised completely at the same time [Neumann (1984)]. It is further argued that sterilisation is capable to move exchange rates through either a portfolio or signaling channel. In developing countries, an intervention may not be used purely to stabilise exchange rate but to reduce its impacts of volatile exchange rates on price level.
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