THE ECONOMICS OF MONEY,BANKING, AND FINANCIAL MARKETS 554

522 PA R T V I International Finance and Monetary Policy the exchange rate rises An unsterilized intervention in which domestic currency is purchased by selling foreign assets leads to a drop in international reserves, a decrease in the money supply, and an appreciation of the domestic currency Sterilized Intervention The key point to remember about a sterilized intervention is that the central bank engages in offsetting open market operations, so that there is no impact on the monetary base and the money supply In the context of the model of exchange rate determination we have developed here, it is straightforward to show that a sterilized intervention has almost no effect on the exchange rate A sterilized intervention leaves the money supply unchanged and so has no direct way of affecting interest rates or the expected future exchange rate.2 Because the relative expected return on dollar assets is unaffected, the demand curve would remain at D1 in Figure 20-1, and the exchange rate would remain unchanged at E1 At first it might seem puzzling that a central bank purchase or sale of domestic currency that is sterilized does not lead to a change in the exchange rate A central bank purchase of domestic currency cannot raise the exchange rate, because with no effect on the domestic money supply or interest rates, any resulting rise in the exchange rate would mean that there would be an excess supply of dollar assets With more people willing to sell dollar assets than to buy them, the exchange rate would have to fall back to its initial equilibrium level, where the demand and supply curves intersect BALAN CE OF PAYME N TS Because international financial transactions such as foreign exchange interventions have considerable effects on monetary policy, it is worth knowing how these transactions are measured The balance of payments is a bookkeeping system for recording all receipts and payments that have a direct bearing on the movement of funds between a nation (private sector and government) and foreign countries Here we examine the key items in the balance of payments that you often hear about in the media.3 The current account shows international transactions that involve currently produced goods and services The difference between merchandise exports and imports, the net receipts from trade, is called the trade balance When exports A sterilized intervention changes the amount of foreign securities relative to domestic securities in the hands of the public, called a portfolio balance effect Through this effect, the central bank might be able to affect the interest differential between domestic and foreign assets, which in turn affects the relative expected return of domestic assets Empirical evidence has not revealed this portfolio balance effect to be significant However, a sterilized intervention could indicate what central banks want to happen to the future exchange rate and so might provide a signal about the course of future monetary policy In this way a sterilized intervention could lead to shifts in the demand curve for domestic assets and ultimately affect the exchange rate However, the future change in monetary policy not the sterilized intervention is the source of the exchange rate effect For a further discussion of the signalling and portfolio balance effects and the possible differential effects of sterilized versus unsterilized intervention, see Paul Krugman and Maurice Obstfeld, International Economics, 7th ed (Boston: Addison-Wesley, 2006) A Web Appendix to this chapter on this book s MyEconLab at www.pearsoned.ca/myeconlab discusses the Canadian balance of payments in more detail