A rapidly developing economy is experiencing significant capital inflows, primarily in the form of portfolio investments. The central bank is concerned that these inflows are contributing to an appreciation of the domestic currency, threatening the competitiveness of export-oriented industries. Which of the following policy combinations would be most effective in mitigating the currency appreciation while also addressing potential inflationary pressures from the capital inflows?
- ACapital controls to limit inflows combined with a decrease in reserve requirements.
- BSterilized foreign exchange intervention combined with a reduction in government spending.
- CUnsterilized foreign exchange intervention combined with interest rate hikes.
- DSterilized foreign exchange intervention combined with fiscal expansion.
Show answer & explanationAnswer & explanation
Correct answer: B. Sterilized foreign exchange intervention combined with a reduction in government spending.
Sterilized foreign exchange intervention involves the central bank selling domestic currency (to buy foreign currency, resisting appreciation) and simultaneously selling government bonds to absorb the newly injected domestic currency, thus preventing an increase in the money supply and inflationary pressure. Combining this with fiscal contraction (reduction in government spending) further reduces aggregate demand, which helps to curb inflation and can also reduce demand for foreign goods (improving the trade balance and potentially easing appreciation pressure).
Why the other options are wrong
- A. Incorrect. While capital controls can limit inflows, decreasing reserve requirements is an expansionary monetary policy that would increase the money supply and inflationary pressures.
- C. Incorrect. Unsterilized intervention allows the money supply to increase, which would lead to inflation. Interest rate hikes would attract more capital, exacerbating appreciation.
- D. Incorrect. Fiscal expansion would increase aggregate demand and potentially inflationary pressures, counteracting the goal of addressing inflation.
Sterilized Foreign Exchange Intervention
A central bank's intervention in the foreign exchange market to buy or sell foreign currency, where the monetary impact of the intervention is offset through simultaneous open market operations.
- Aims to influence the exchange rate without affecting the domestic money supply.
- Involves matching foreign exchange transactions with offsetting domestic bond transactions.
- Effectiveness can be limited if capital mobility is high and intervention is prolonged.
Memory trick: Sterilize the flow, trim the spend, keep the economy stable.