THE ECONOMICS OF MONEY,BANKING, AND FINANCIAL MARKETS 554

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PA R T V I

International Finance and Monetary Policy
the exchange rate rises. An unsterilized intervention in which domestic currency is purchased by selling foreign assets leads to a drop in international reserves, a decrease in the money supply, and an appreciation of
the domestic currency.

Sterilized
Intervention

The key point to remember about a sterilized intervention is that the central bank
engages in offsetting open market operations, so that there is no impact on the
monetary base and the money supply. In the context of the model of exchange
rate determination we have developed here, it is straightforward to show that a
sterilized intervention has almost no effect on the exchange rate. A sterilized intervention leaves the money supply unchanged and so has no direct way of affecting interest rates or the expected future exchange rate.2 Because the relative
expected return on dollar assets is unaffected, the demand curve would remain at
D1 in Figure 20-1, and the exchange rate would remain unchanged at E1.
At first it might seem puzzling that a central bank purchase or sale of domestic currency that is sterilized does not lead to a change in the exchange rate. A central bank purchase of domestic currency cannot raise the exchange rate, because
with no effect on the domestic money supply or interest rates, any resulting rise
in the exchange rate would mean that there would be an excess supply of dollar
assets. With more people willing to sell dollar assets than to buy them, the
exchange rate would have to fall back to its initial equilibrium level, where the
demand and supply curves intersect.

BALAN CE OF PAYME N TS
Because international financial transactions such as foreign exchange interventions
have considerable effects on monetary policy, it is worth knowing how these
transactions are measured. The balance of payments is a bookkeeping system
for recording all receipts and payments that have a direct bearing on the movement of funds between a nation (private sector and government) and foreign
countries.

Here we examine the key items in the balance of payments that you often hear
about in the media.3
The current account shows international transactions that involve currently
produced goods and services. The difference between merchandise exports and
imports, the net receipts from trade, is called the trade balance. When exports

2

A sterilized intervention changes the amount of foreign securities relative to domestic securities in the
hands of the public, called a portfolio balance effect. Through this effect, the central bank might be
able to affect the interest differential between domestic and foreign assets, which in turn affects the
relative expected return of domestic assets. Empirical evidence has not revealed this portfolio balance
effect to be significant. However, a sterilized intervention could indicate what central banks want
to happen to the future exchange rate and so might provide a signal about the course of future monetary policy. In this way a sterilized intervention could lead to shifts in the demand curve for domestic
assets and ultimately affect the exchange rate. However, the future change in monetary policy not
the sterilized intervention is the source of the exchange rate effect. For a further discussion of the
signalling and portfolio balance effects and the possible differential effects of sterilized versus unsterilized intervention, see Paul Krugman and Maurice Obstfeld, International Economics, 7th ed. (Boston:
Addison-Wesley, 2006).

3

A Web Appendix to this chapter on this book s MyEconLab at www.pearsoned.ca/myeconlab discusses the Canadian balance of payments in more detail.