International macroe.. - Free

1.3. THE CENTRAL BANK’S BALANCE SHEET 21Mechanics of InterventionSuppose that the central bank wants to the dollar to fall in value againstthe yen. To achieve this result, it must buy yen which increases NFA cb ,B, and hence the money supply M. If the Fed buys the yen fromCitibank (say), in New York, the Fed pays for the yen by creditingCitibank’s reserve account. Citibank then transfers ownership of a yendeposit at a Japanese bank to the Fed.If the intervention ends here the US money supply increases but theJapanese money supply is unaffected. In Japan, all that happens is aswap of deposit liabilities in the Japanese commercial bank. The Fedcould go a step further and convert the deposit into Japanese T-bills.It might do so by buying T-bills from a Japanese resident which it paysfor by writing a check drawn on the Japanese bank. The Japaneseresident deposits that check in a bank, and still, there is no net effecton the Japanese monetary base.If, on the other hand, the Fed converts the deposit into currency,the Japanese monetary base does decline. The reason for this is thatthe Japanese monetary base is reduced when the Fed withdraws currencyfrom circulation. The Fed would never do this, however, becausecurrency pays no interest. The intervention described above is referredto as an unsterilized intervention because the central bank’s foreign exchangetransactions have been allowed to affect the domestic moneysupply. A sterilized intervention, on the other hand occurs when thecentral bank offsets its foreign exchange operations with transactionsin domestic credit so that no net change in the money supply occurs.To sterilize the yen purchase described above, the Fed would simultaneouslyundertake an open market sale, so that D would decrease byexactly the amount that NFA cb increases from the foreign exchange intervention.It is an open question whether sterilized interventions canhave a permanent effect on the exchange rate.