Sterilization - Monetary economy. Theory of money and credit

Sterilization

In an open economy, the central bank can not simultaneously and arbitrarily control both the internal interest rate and the exchange rate. The money supply in an open economy is subject to the influence not only of the central bank and domestic economic agents, but also of the external sector. To maintain the supply of money at a stable level and control over the sharp fluctuations in the parameters of the money supply in an open economy, the central bank uses a sterilization policy.

Sterilization - the Central Bank's actions to neutralize changes in the money supply under the influence of changes in the balance of payments are made through operations on the open market.

Suppose there is a deficit in the balance of payments in the country. This means that cash flows are sent from a country abroad. Demand for the national currency is declining, which could lead to a depreciation of the national currency. If the state does not want to allow such a development of events, to support the exchange rate, it is necessary to reduce the money supply (for example, by buying up national money by selling international reserves). But the reduction of the money supply inside the country can negatively affect the domestic economic processes, for example, firms may not have enough liquidity to expand their activities. Therefore, the Central Bank conducts another operation aimed at returning the money supply to the previous level. For this, the central bank buys government bonds on the open market. The number of bonds in circulation decreases, the money supply increases to the previous optimal value.

The opposite situation occurs in the case of a surplus of the balance of payments. A positive balance of payments means an inflow of capital into the country and an increase in demand for the national currency, which should be accompanied by the strengthening of the national currency. Since the increase in the exchange rate is not always in the interest of the national economy, in order to maintain a lower rate, the Central Bank can sell the national currency to international reserves. Then in the economy will be a very large amount of money supply, which can lead to inflation. Now you need an action to remove unnecessary money from the economy. For this, the central bank conducts the sale of government bonds on the open market. The volume of bonds in free circulation increases, and the money supply is reduced to the initial level.

Table 14.1 summarizes the policy of sterilization in an open economy.

Table 14.1

Sterilization in an open economy

Balance of Payments	Change in money supply	Actions of the Central Bank in the open market
PB deficiency	M S ↓	Purchase of government bonds
PB surplus	M s ↑	Sale of government bonds

Thus, the policy of sterilization is accompanied by two actions of the central bank with the opposite result. In the foreign exchange market, the Central Bank operates international reserves (official reserve accounts) to support the exchange rate. In the open market (government bond market), the Central Bank buys and sells government bonds - to neutralize the money supply. As a result, neither the exchange rate nor the amount of money supply in the economy is changing.

Monetary policy in an open economy is used in many ways with the same goals as in a closed economy: controlling inflation, stimulating domestic aggregate demand and economic growth, preventing a sharp drop in output and the economic downturn. Common mechanisms of monetary policy in open and closed economies are inflation targeting, control of the monetary base, targeting nominal GDP. To them in the open economy, the exchange rate targeting (exchange rate targeting) is added.