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I'm looking to see if someone can help improve my understanding of sterilized intervention in FX markets.

My intuition/understanding is:

  • Assume that the domestic currency is depreciating, perhaps due to a trade deficit (let's say temporary for now) - if the domestic central bank wants to avoid depreciation, they use some of their foreign reserves (of the foreign currency) to buy domestic currency.
  • This would increase supply of the foreign currency, decrease supply of the domestic and therefore help prop up the domestic currency.
  • However, this would reduce the monetary base of the domestic currency (as some of it has now disappeared into the central bank which doesn't participate in the economy, and hence doesn't count towards supply).
  • Therefore, a sterilized intervention occurs when the central bank uses its newly acquired domestic currency to buy domestic bonds, which re-injects the domestic currency back into the money supply.
  • This leaves
    • the foreign currency supply higher than when we started and
    • the domestic supply unchanged from the start.
  • Therefore, this increased supply of the foreign currency devalues the foreign currency and hence helps prevent the domestic currency from depreciating.
  • To have the same level of effect on exchange rate as an unsterilized intervention, one may have to intervene to a greater extent (since only the foreign supply is increasing).

Is the above roughly correct? Is there some other reason / mechanism via which the exchange rate is being maintained? The main thing I'd like to understand is whether it is really this increased supply of foreign currency that is causing the effect or whether this is some other mechanism.

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