Sterilization and Non-sterilization

Studies of foreign exchange intervention generally distinguish between intervention that does or does not change the monetary base. The former type is called non-sterilized intervention while the latter is referred to as sterilized intervention. Central banks sometimes carry out equal foreign and domestic assets transaction in opposite directions to nullify the impact of their foreign exchange operations on the domestic money supply.

When a monetary authority buys (sells) foreign exchange, its own monetary base increases (decreases) by the amount of the purchase (sale). In order to prevent the money stock from increasing (decreasing), the monetary authorities can sterilize the effect of the exchange market intervention by selling (buying) short-term domestic assets to (from) the banking system leaving the monetary base of the country unchanged. Since sterilized intervention does not affect the money supply, it does not affect prices or interest rate and so does not influence the exchange rate. Rather, sterilized intervention might affect the foreign exchange market through two routes: the portfolio-balance channel and the signaling channel.

According to the portfolio-balance channel, it is assumed that risk-averse wealth holders diversify their portfolio across assets denominated in different currencies. Let's use the United States and Japan as an example. The portfolio balance channel theory holds that sterilized purchases of yen raise the dollar price of yen because investors must be compensated with a higher expected return to hold the relatively more numerous U.S. bonds. To produce a higher expected return, the yen price of the U.S. bonds must fall immediately. That is, the dollar price of yen must rise.

In contrast, the signaling channel assumes that intervention affects exchange rates by providing the market with new relevant information, under an implicit assumption that the authorities have superior information to other market participants. The authorities are willing to reveal this information through their actions in the foreign exchange market. Because private agents may change their exchange rate expectation after intervention, the exchange rate then will be expected to change immediately after the effect occurs.