B sterilized intervention 1 in a sterilized

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B. Sterilized Intervention 1. In a sterilized intervention, a change in foreign exchange reserves alters the asset side of the central bank’s balance sheet, but the domestic monetary base remains unaffected. 2. A sterilized intervention is actually a combination of two transactions, the purchase (or sale) or foreign currency reserves and an open market operation of exactly the same size, designed to offset the impact of the first transaction on the monetary base. 3. The intervention changes the composition of the asset side of the central bank’s balance sheet but not its size. II. The Costs, Benefits, and Risks of Fixed Exchange Rates C. Assessing the Costs and Benefits 1. Fixed exchange rates simplify operations for businesses that trade internationally and reduce the risk that investors face when they hold foreign stocks and bonds as well. Instructor’s Manual t/a Cecchetti: Money, Banking, and Financial Markets 18
Chapter 19 Exchange-Rate Policy and the Central Bank 2. A fixed exchange rate ties policymakers’ hands, and in countries that are prone to bouts of high inflation, a fixed exchange rate may be the only way to establish a credible low-inflation policy. 3. An exchange rate target enforces low-inflation discipline on both central banks and politicians and enhances transparency and accountability. 4. There is one serious drawback to a fixed exchange rate; it means importing monetary policy. 5. Fixing your currency to that of another country means adopting the interest rate policy of the other country, which can be a real problem if the two countries have different macroeconomic fluctuations. 6. In order to fix the rate, the central bank must have ample reserves because it will need to buy (and sell) its currency at the fixed rate; such reserves may be difficult to obtain and expensive to keep. 7. Fixing the exchange rate also means reducing the domestic economy’s natural ability to respond to macroeconomic shocks. The stabilization mechanism of interest rates is shut down. D. The Danger of Speculative Attacks 1. Fixed exchange rates are fragile and are prone to a type of crisis called a speculative attack. 2. If traders believe that the reserves at the central bank are insufficient they can launch an attack and, in effect, drain those reserves. 3. Speculative attacks are caused by traders not believing that officials can maintain the exchange rate at its fixed level (perhaps due to expectations of inflation) but can also arise spontaneously (and can be contagious). E. Summarizing the Case for a Fixed Exchange Rate 1. A country will be better off fixing its exchange rate if it has a poor reputation for controlling inflation on its own, an economy that is well integrated with the one to whose currency the rate is fixed, and a high level of foreign exchange reserves.

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