Sterilized intervention under excess supply of foreign exchange: Is the Trilemma valid?

This article explores the challenges of monetary policy in small open economiesfacing a sustained excess supply of foreign exchange (FX) in the domestic market. In thiscontext, the conventional prescription based on the open-economy trilemma suggests that central banks cannot simultaneously manage both interest rates and exchange rates. However,governments may wish to continue conducting monetary policy while avoiding domesticcurrency appreciation, as this could conflict with their development goals. Can policymakersavoid the trilemma prescription in this case? The article analyzes the theoreticalfoundations of the trilemma and discusses its potential limitations. It begins by examiningthe uncovered interest parity (UIP) condition, which underpins the trilemma, emphasizingthat arbitrage forces do not always equilibrate returns due to factors such as market incompleteness,transaction costs, and exchange rate risk/uncertainty. It then demonstrates that, inthe case of an excess supply of foreign currency, the central bank can intervene in the FXmarket and use sterilization to maintain interest rates unchanged, provided it has the capacityto issue domestic bonds. The central bank’s ability to endogenously adjust the supply ofdomestic assets to meet excess demand is a key theoretical element that contradicts the trilemma,which implicitly assumes that the stocks of both domestic and foreign assets arefixed. Finally, a model is developed to assess the conditions under which central banks cansuccessfully manage both interest rates and exchange rates while fulfilling the solvency condition. JEL Classification: E52; F31; F41.