Model Answer
0 min readIntroduction
Exchange rate regimes determine how a country’s currency value is managed. While a completely fixed exchange rate is rare, and a purely free float can be volatile, many countries adopt intermediate regimes. Managed floating, a common choice, allows exchange rates to be determined by market forces but with occasional central bank intervention. Sterilized intervention is a specific technique used within a managed float to influence domestic monetary conditions while maintaining the exchange rate objective. Understanding these concepts is crucial for analyzing macroeconomic policy and international finance.
Managed Floating Exchange Rate
Managed floating, also known as a ‘dirty float’, is an exchange rate regime where the exchange rate is primarily determined by market forces of supply and demand. However, the central bank actively intervenes in the foreign exchange market to moderate fluctuations, prevent excessive volatility, or achieve specific exchange rate objectives. This intervention isn’t aimed at rigidly fixing the exchange rate but rather at influencing its direction or pace of change.
- Intervention Mechanisms: Central banks can intervene by buying or selling their own currency in the foreign exchange market. Buying their own currency increases demand, appreciating its value, while selling increases supply, depreciating its value.
- Objectives: Common objectives include smoothing exchange rate fluctuations, preventing disruptive appreciation or depreciation, and maintaining competitiveness.
- Example: The Reserve Bank of India (RBI) frequently intervenes in the foreign exchange market to manage the volatility of the Indian Rupee, particularly against the US Dollar.
Sterilized Intervention
Sterilized intervention is a specific type of foreign exchange intervention where the central bank simultaneously undertakes foreign exchange operations and offsetting domestic open market operations to prevent any change in the domestic money supply. This is done to influence the exchange rate without affecting interest rates or credit conditions.
- How it Works: If a central bank wants to appreciate its currency, it buys its own currency in the foreign exchange market (increasing demand). To sterilize this, it simultaneously sells government bonds in the domestic market (reducing the money supply). The bond sale offsets the increase in the money supply caused by the currency purchase, keeping the overall money supply unchanged.
- Objectives: The primary objective is to influence the exchange rate without altering domestic monetary policy. This is useful when a country wants to manage its exchange rate while also pursuing independent monetary policy goals, such as controlling inflation.
- Effectiveness: The effectiveness of sterilized intervention is debated. Some economists argue it has limited impact, especially in open economies with high capital mobility, as capital flows can counteract the central bank’s efforts.
- Example: In the early 2000s, several East Asian central banks, including those of Thailand and South Korea, used sterilized intervention to prevent their currencies from appreciating rapidly against the US Dollar.
Comparison: Managed Floating vs. Sterilized Intervention
| Feature | Managed Floating | Sterilized Intervention |
|---|---|---|
| Nature of Intervention | Broad; can involve various degrees of intervention. | Specific; always accompanied by offsetting domestic operations. |
| Impact on Money Supply | Can alter the money supply. | Aims to keep the money supply unchanged. |
| Objective | Moderate fluctuations, prevent excessive volatility, achieve exchange rate objectives. | Influence exchange rate without affecting domestic monetary conditions. |
| Complexity | Relatively simpler to implement. | More complex, requiring coordinated operations. |
Conclusion
Both managed floating and sterilized intervention are tools used by central banks to influence exchange rates. Managed floating provides flexibility while allowing for intervention, while sterilized intervention offers a way to manage the exchange rate without disrupting domestic monetary policy. However, the effectiveness of both approaches can be limited by factors such as capital mobility and market expectations. The choice between these strategies depends on a country’s specific economic circumstances and policy priorities.
Answer Length
This is a comprehensive model answer for learning purposes and may exceed the word limit. In the exam, always adhere to the prescribed word count.