Agung Yuda Pratama

195020407111023

Intervention In The Foreign Exchange Market

We can see in the T-account above for the Federal Reserve: The Fed’s purchase of
dollars has two effects. First, it reduces the Fed’s holdings of international reserves
by $1 billion. Second, because the Fed’s purchase of currency removes it from the
hands of the public, currency in circulation falls by $1 billion.

Because reserves are a component of the monetary basis, the Fed's sale of foreign
assets and purchase of dollar deposits results in a $1 billion decline in reserves and,
as previously stated, a $1 billion decline in the monetary base.

A central bank’s purchase of domestic currency and corresponding sale of

foreign assets in the foreign exchange market leads to an equal decline in its
international reserves and the monetary base.

A central bank’s sale of domestic currency to purchase foreign assets in the

foreign exchange market results in an equal rise in its international reserves and
the monetary base.
The T-account above happen when the central bank does not want the purchase or
sale of domestic currency to affect the monetary base. All it has to do is counteract
the effect of the foreign exchange intervention by conducting an offsetting open
market operation in the government bond market.

Unsterilized Intervention

If the Federal Reserve decides to sell dollars in order to purchase foreign assets in
the foreign exchange market, this operates in the same way as an open market
purchase of bonds to grow the monetary base does. As a result, purchasing dollars
reduces the money supply, raising the domestic interest rate and increasing the
relative expected return on dollar assets. As a result, the demand curve shifts to the
right from D1 to D2, as shown in the figure, and the exchange rate rises to E2.

An unsterilized intervention in which domestic currency is bought and foreign

assets are sold leads to a fall in international reserves, a fall in the money
supply, and an appreciation of the domestic currency.

The reverse result is found for an unsterilized intervention in which domestic

currency is sold and foreign assets are purchased. The increase in the money supply
reduces the interest rate on dollar assets. As a result of the decrease in the relative
expected return on dollar assets, consumers would acquire less dollar assets,
causing the demand curve to move to the left and the exchange rate to fall.

An unsterilized intervention in which domestic currency is sold and foreign

assets are purchased leads to a rise in international reserves, a rise in the
money supply, and a depreciation of the domestic currency.
Sterilized Intervention
the central bank conducts offsetting open market operations, the monetary base and
money supply are unaffected. It is a simple task to demonstrate that a sterilized
intervention has practically little influence on the exchange rate in the context of the
model of exchange rate determination that we have established here. A sterilized
intervention has no direct effect on interest rates since it does not modify the money
supply. 2 Because the relative expected return on dollar assets stays unchanged,
the demand curve in Figure 1 remains at D1, and the exchange rate remains at E1.

A central bank purchase of domestic currency cannot boost the exchange rate
because, with no influence on domestic money supply or interest rates, any
consequent rise in the exchange rate would result in an excess supply of dollar
assets. When there are more persons wanting to sell dollar assets than purchase
them, the exchange rate returns to its initial equilibrium level, where the demand and
supply curves cross.