THE ECONOMICS OF MONEY,BANKING, AND FINANCIAL MARKETS 552

520 PA R T V I International Finance and Monetary Policy The intervention we have just described, in which a central bank allows the purchase or sale of domestic currency to have an effect on the monetary base, is called an unsterilized foreign exchange intervention But what if the central bank does not want the purchase or sale of domestic currency to affect the monetary base? All it has to is to counter the effect of the foreign exchange intervention by conducting an offsetting open market operation in the government bond market For example, in the case of a $1 billion purchase of dollars by the Bank of Canada and a corresponding $1 billion sale of foreign assets, which we have seen would decrease the monetary base by $1 billion, the Bank can conduct an open market purchase of $1 billion of government bonds, which would increase the monetary base by $1 billion The resulting T-account for the foreign exchange intervention and the offsetting open market operation leaves the monetary base unchanged: Bank of Canada Assets Foreign assets (international reserves) Government bonds Liabilities *$1 billion +$1 billion Monetary base (reserves) A foreign exchange intervention with an offsetting open market operation that leaves the monetary base unchanged is called a sterilized foreign exchange intervention Now that we understand that there are two types of foreign exchange interventions, unsterilized and sterilized, let s look at how each affects the exchange rate Unsterilized Intervention Your intuition might lead you to suspect that if a central bank wants to lower the value of the domestic currency, it should sell its currency in the foreign exchange market and purchase foreign assets Indeed, this intuition is correct for the case of an unsterilized intervention Recall that in an unsterilized intervention, if the Bank of Canada decides to sell dollars so that it can buy foreign assets in the foreign exchange market, this works just like an open market purchase of bonds to increase the monetary base Hence the sale of dollars leads to an increase in the money supply, and we find ourselves analyzing a similar situation to that described in Figure 19-8 (page 512), which is reproduced here as Figure 20-1.1 The higher money supply leads to a higher Canadian price level in the long run and so to a lower expected future exchange rate The resulting decline in the expected appreciation of the dollar lowers the relative expected return on dollar assets and shifts the demand curve to the left In addition, the increase in the money supply will An unsterilized intervention in which the Bank of Canada sells dollars increases the amount of dollar assets slightly because it leads to an increase in the monetary base while leaving the amount of government bonds in the hands of the public unchanged The curve depicting the supply of dollar assets would thus shift to the right slightly, which also works toward lowering the exchange rate, yielding the same conclusion derived from Figure 20-1 Because the resulting increase in the monetary base would be only a minuscule fraction of the total amount of dollar assets outstanding, the supply curve would shift by an imperceptible amount This is why Figure 20-1 is drawn with the supply curve unchanged