CFA Level II ExamEconomicsMedium
A central bank in a developed economy implements a policy to sterilize its foreign exchange intervention. The central bank sells $5 billion worth of foreign currency in the open market to prevent domestic currency appreciation. To sterilize this action, which of the following additional operations should the central bank undertake?
- AIncrease the reserve requirement for commercial banks.
- BBuy an equivalent amount of government bonds in the open market.
- CSell an equivalent amount of government bonds in the open market.
- DDecrease the discount rate for commercial banks.
Show answer & explanationAnswer & explanation
Correct answer: B. Buy an equivalent amount of government bonds in the open market.
The initial sale of foreign currency by the central bank absorbs domestic currency from circulation, contracting the money supply. To sterilize this and offset the impact on the domestic money supply, the central bank must inject an equivalent amount of domestic currency back into the economy by buying government bonds in the open market.
Why the other options are wrong
- A. Increasing the reserve requirement would also contract the money supply, exacerbating the initial effect.
- C. Selling government bonds would further contract the money supply, intensifying the original intervention's effect, not sterilizing it.
- D. Decreasing the discount rate would encourage borrowing and increase the money supply, but open market operations (buying bonds) are the direct and equivalent sterilization tool for foreign exchange interventions.
Sterilized Foreign Exchange Intervention
A foreign exchange intervention where the central bank conducts an offsetting open market operation to neutralize the impact of the intervention on the domestic money supply.
- Central bank acts in the foreign exchange market (buys/sells foreign currency).
- Simultaneously acts in the domestic bond market (sells/buys domestic bonds).
- Goal is to influence the exchange rate without affecting the domestic money supply.
- If foreign currency is sold, domestic currency is absorbed; sterilization requires injecting domestic currency (buying bonds).
- If foreign currency is bought, domestic currency is injected; sterilization requires absorbing domestic currency (selling bonds).
Memory trick: FX move, then bond countermove, money supply stays in its groove.