Unsterilized Intervention Definition & Examples

Published Sep 8, 2024

Definition of Unsterilized Intervention

Unsterilized intervention is a monetary policy tool used by central banks to influence the value of their currency on the foreign exchange market without offsetting the impact on the domestic money supply. In an unsterilized intervention, the central bank buys or sells foreign currency, affecting both the exchange rate and the domestic money supply. By doing so, unsterilized intervention differs from sterilized intervention, where the central bank uses additional measures to neutralize any impact on the money supply.

Example

Let’s consider a scenario involving the central bank of Country A, which wants to devalue its currency against the US dollar to make its exports more competitive. The central bank will enter the foreign exchange market and buy US dollars while selling its domestic currency, say the A-Dollar (AD).

This act of buying US dollars increases the demand for US dollars and increases the supply of AD, leading to a depreciation of AD in the forex market.
As a consequence, the domestic money supply of AD increases because the central bank is injecting AD into the economy without taking any measures to absorb this liquidity.

Now, let’s say Country A’s central bank does not undertake any action to neutralize this increase in the AD money supply. This is a classic example of unsterilized intervention. As AD depreciates, Country A’s exports become cheaper for foreign buyers, potentially boosting the country’s export sector. However, the increase in the money supply may lead to inflationary pressures within Country A.

Why Unsterilized Intervention Matters

Unsterilized intervention is a significant tool for central banks because it directly impacts both the exchange rate and domestic money supply. It can be used to:

Influence exchange rates quickly and effectively to address economic issues such as trade imbalances or to meet specific macroeconomic objectives like boosting exports.
Provide short-term relief in situations where domestic currency valuation is misaligned with economic fundamentals.

However, the procedure also comes with risks:

Uncontrolled increases in money supply can lead to inflation, destabilizing the economy in the long term.
Frequent use of unsterilized intervention might undermine the credibility of the central bank’s monetary policy, leading to increased market volatility.

Thus, policymakers need to carefully weigh the benefits and risks when considering unsterilized intervention as a tool of monetary policy.

Frequently Asked Questions (FAQ)

How does unsterilized intervention differ from sterilized intervention?

Unsterilized intervention impacts both the exchange rate and the domestic money supply. When a central bank buys or sells foreign currency in an unsterilized fashion, it does not take additional steps to neutralize the impact on the money supply. This can lead to changes in domestic inflation and economic activity.
Sterilized intervention, on the other hand, involves offsetting the effect on money supply through additional measures like open market operations. For example, if the central bank buys foreign currency, it might sell government bonds to absorb the extra liquidity from the market, thereby preventing changes in the money supply.

What are the potential long-term impacts of unsterilized intervention?

Long-term impacts of unsterilized intervention can include:

Inflation: By increasing the money supply without compensatory measures, there is a risk of causing inflation, as more money chases the same amount of goods and services.
Economic Instability: If market participants anticipate frequent intervention, it could lead to market instability and lack of confidence in the national currency.
Interest Rates: Changes in the money supply can affect interest rates, potentially impacting borrowing costs, investment, and consumption in the domestic economy.

In what situations would a central bank prefer unsterilized intervention over sterilized intervention?

A central bank might prefer unsterilized intervention over sterilized intervention in situations where:

The central bank aims for a more significant and immediate impact on the exchange rate and is willing to accept the accompanying changes in domestic money supply.
The economic environment necessitates an increase in money supply, such as during a period of deflation or recession, where extra liquidity could stimulate economic activity.
Administrative or operational difficulties make it challenging to carry out the sterilization measures in a timely or efficient manner.

Are there any examples of countries successfully using unsterilized intervention?

Yes, there are examples of countries successfully using unsterilized intervention:

China: China’s central bank, the People’s Bank of China (PBOC), has occasionally used unsterilized interventions to manage its exchange rate. In the past, the PBOC accumulated large amounts of foreign reserves through unsterilized purchases of foreign currency.
Argentina: During periods of economic crises, Argentina has used unsterilized interventions to stabilize its currency, although these measures have often been accompanied by significant inflationary pressures.

In both cases, the interventions were part of broader economic strategies, and their effectiveness depended on various internal and external factors influencing the overall economic context.