Exchange Rate Regimes, Interventions, and the Money Supply

In this chapter, we have discussed unsterilized foreign exchange intervention where the central bank sells foreign assets to the nonbanking public. It results in contraction of money supply which results in increase in interest rate and depreciation of exchange rate. In a situation where the central bank sells foreign assets and turns around to use the proceeds to purchase bonds from the public, the net effect of the policy is zero, as the interest rate remains the same. The policy is referred to as a sterilized intervention. In the situation of a flexible exchange rate regime, the market determined exchange rate requires no central bank intervention. However, under a fixed exchange rate, there is a need for the central bank to enforce the par value of the exchange rate. Thus, an over-valued exchange rate where the market determined exchange rate is below the par value the central bank has chosen, there is a need for the central bank to use sterilized intervention to maintain the par value of the over-valued exchange rate. Similarly, the central bank must use reverse policy intervention to defend the par valued exchange under a fixed exchange rate regime. Speculation becomes a serious threat when the central bank is operating a fixed exchange rate regime. In such situation an over-valued fixed exchange rate is worsened by speculators who tend to demand more of the stronger currency and worsen the situation by hoarding it. The situation of mobility of capital market is also discussed. In this situation, the oil that will be required to ensure smooth running of market forces will be absence of restrictions and barriers associated with higher taxes or tariffs.