Sterilized intervention - CFA 2014 Mock Question

CFA Level II
#1

Sterilized intervention

  • gov’t sells securities to reduce effects of FX intervention
  • Monetary base and short term rates unaffected

Can anyone explain this? How does selling securities reduce the effects of FX intervention???

#2

As you sell domestic currencies in FX market to slow down the appreciation, you increase supply in the market and fuel higher inflation. By selling securities to private sector in the market, you absorb the excess supply and hence effectively slow down currency appreciation and prevent higher inflation.

#3

Sorry, but that was confusing, you said you sell domestic currencies (this means the same as selling securities to me, you’re taking money supply back effectively and promise to give them increments of the payment back, think treasury) to slow appreciation and increase M/S, then you say, you sell securities to absorb M/S and decrease M/S, to prevent inflation.

Which one?

My understanding is that you sell securities to keep inflation low and SHORT TERM interest rates down (because if you keep M/S low, long term interest rates rise in order to induce banks to lend, otherwise there’s no incentive).

Someone correct me if I’m wrong please.

#4

Sterlized intervention contracts the money supply by selling securities into the banking system. It does so to prevent short term rates from going up on the back of excess liquidity. This is beneficial if you don’t want your currency to experience further appreciation from foreign inflow of capital.

The unsteralized intervention I believe is buying foreign currency on the open market to keep the exchange rate under control. I could be wrong about that though.

#5

Sterilized intervention, if domestic currency is too strong :

  • Gov sell foreign denominated asset in the FX (thereby printing domestic currencies, pushing the exchange rate down and increasing liquidity)

  • Gov buy domestic securities in the open market (thereby removing the liquidity added by the FX intervention)

Basically the gov swap a foreign asset for a domestic security. It will do the inverse if the currency is too weak (buying foreign asset in FX market to push the exchange rate up, and selling domestic asset in open market to remove the liquidity added by the FX intervention).

Unsterilized intervention means no open market intervention (no buy/selling of domestic securitie) to offest the effect of the FX intervention (buying/selling foreign denominated asset).

#6

A sterilized intervention leaves the monetary based unaffected, and an unsterilized intervention will change the monetary base. There can be buying or selling (in the FX market) for either of these. The difference between the two is whether the monetary base changes as a result of the intervention.