What is the difference between sterilized and unsterilized intervention?
Recently I’ve been trying to get my head around the difference between a “sterilized” asset purchase by a central bank and an “unsterilized” purchase. Here is where I’ve gotten to – happy for any comments or clarifications!
Such purchases are predominantly with regards to foreign exchange – so there are related asset transactions on a forex market, and within a domestic market. However, I’m going to use the term a bit more broadly – as with a variety of forms of asset purchases by central banks, I think the term has a broader relevance.
Sterilized intervention is when the central bank makes a purchase of an asset, then sells a corresponding asset to try to keep the “money supply” fixed. So the idea behind sterilization is that it should NOT have monetary policy effects. However, there may be a reason why the change in the asset composition of the central bank’s balance sheet is important for its “bank regulator” role.
As an example, Central Bank of China uses sterilized intervention to lower their currency but keep domestic monetary policy going. In that context this is also a form of “capital control” in terms of the impossible trinity (trilemma between a fixed exchange rate, free capital flows, and monetary policy independence). We may do this to reduce volatility in exchange rates, or as a form of “illegal” trade policy (in a simple language, this is forcing domestic citizens to save in order to build up reserves and generate trade surpluses).
When the central bank uses an unsterilized intervention this changes the money supply in economy.
An example of this could be a helicopter money drop. The increase in the amount of money leads to a real balance sheet effect. This example is when government just credits households’ bank account, which incentivises the latter to spend.
In this case, there is no need to worry about Ricardian Equivalence as the government doesn’t borrow to cover off the money supply. If output was fixed this would merely lead to prices going up – but if there are factors of production being “left idle” it can lead to output. Hence why unsterilized intervention expected to lead to increase in “planned expenditure”.
Forex fits into this space because the unsterilized intervention in turn increases the “supply” of money (all other things equal) which can be used for the purchase on goods and services with that fiat currency. As a result, unless that currency is held externally as an asset it will in turn increase demand for the goods and services in that economy.