THE ECONOMICS OF MONEY,BANKING, AND FINANCIAL MARKETS 552

520

PA R T V I

International Finance and Monetary Policy
The intervention we have just described, in which a central bank allows the
purchase or sale of domestic currency to have an effect on the monetary base, is
called an unsterilized foreign exchange intervention. But what if the central
bank does not want the purchase or sale of domestic currency to affect the monetary base? All it has to do is to counter the effect of the foreign exchange intervention by conducting an offsetting open market operation in the government
bond market. For example, in the case of a $1 billion purchase of dollars by the
Bank of Canada and a corresponding $1 billion sale of foreign assets, which we
have seen would decrease the monetary base by $1 billion, the Bank can conduct
an open market purchase of $1 billion of government bonds, which would
increase the monetary base by $1 billion. The resulting T-account for the foreign
exchange intervention and the offsetting open market operation leaves the monetary base unchanged:
Bank of Canada
Assets
Foreign assets (international reserves)
Government bonds

Liabilities
*$1 billion
+$1 billion

Monetary base
(reserves)

0

A foreign exchange intervention with an offsetting open market operation that
leaves the monetary base unchanged is called a sterilized foreign exchange

intervention.
Now that we understand that there are two types of foreign exchange interventions, unsterilized and sterilized, let s look at how each affects the exchange rate.

Unsterilized
Intervention

Your intuition might lead you to suspect that if a central bank wants to lower the
value of the domestic currency, it should sell its currency in the foreign exchange
market and purchase foreign assets. Indeed, this intuition is correct for the case of
an unsterilized intervention.
Recall that in an unsterilized intervention, if the Bank of Canada decides to
sell dollars so that it can buy foreign assets in the foreign exchange market, this
works just like an open market purchase of bonds to increase the monetary
base. Hence the sale of dollars leads to an increase in the money supply, and
we find ourselves analyzing a similar situation to that described in Figure 19-8
(page 512), which is reproduced here as Figure 20-1.1 The higher money
supply leads to a higher Canadian price level in the long run and so to a lower
expected future exchange rate. The resulting decline in the expected appreciation of the dollar lowers the relative expected return on dollar assets and shifts
the demand curve to the left. In addition, the increase in the money supply will

1

An unsterilized intervention in which the Bank of Canada sells dollars increases the amount of dollar
assets slightly because it leads to an increase in the monetary base while leaving the amount of government bonds in the hands of the public unchanged. The curve depicting the supply of dollar assets
would thus shift to the right slightly, which also works toward lowering the exchange rate, yielding the
same conclusion derived from Figure 20-1. Because the resulting increase in the monetary base would
be only a minuscule fraction of the total amount of dollar assets outstanding, the supply curve would
shift by an imperceptible amount. This is why Figure 20-1 is drawn with the supply curve unchanged.