| | | | | | the fixed rate, as it has promised to do, and in return obtains domestic dollars, which normally would thereby be removed from public circulation, thus decreasing the money supply. (Under a policy of sterilization, of course, the central bank arranges to have these dollars put back into circulation.) The key point here is that during this process the government is selling off its holdings of foreign exchange. As long as the balance of payments deficit continues, the government's stock of foreign exchange its foreign exchange reserves steadily falls. | | | | | | | | | The major problem with sterilization policy should now be evident. By maintaining the balance of payments deficit, the sterilization policy causes the government's foreign exchange reserves to run low, threatening its ability to continue this policy, and worse, alerting foreign exchange speculators that the dollar may soon have to be allowed to fall. The resulting foreign exchange crisis usually results in a devaluation (a substantive fall in the fixed exchange rate value), creating embarrassment for the government and profits for speculators. If a balance of payments surplus is being maintained by a sterilization policy, however, opposite results are obtained. Foreign exchange reserves cumulate to embarrassingly high levels, ultimately causing an upward revaluation of the currency and, once again, profits for speculators. | | | | | | | | | 16.8
Government Influence on the Exchange Rate | | | | | | | | | It is rare to find an exchange rate system that is fully flexible. Usually, government intervenes in the operation of the foreign exchange market to "modify" the natural forces of supply and demand. Sometimes intervention is intended to prop up an exchange rate for reasons of prestige, and at other times it is intended to push down the exchange rate in order to produce jobs through stimulation of demand for exports and import-competing goods and services. Neither of these interventions can be viewed with favor because they attempt to set the exchange rate at an unnatural level. A more convincing rationale for government interference in this market is that without such interference the exchange rate may be volatile, so volatile that it is disruptive to international business activity. Government action designed to cushion temporary shocks to the exchange rate, rather than to influence its long-run level, is thought to be a legitimate policy. | | | | | | | | | The government employs two main mechanisms to influence the exchange rate. First, it can intervene directly in the foreign exchange market, buying or selling dollars. This intervention is viable as long as the government's stock of foreign exchange reserves is not threatened, as it would be, for example, if it tried to keep the exchange rate above its long-run level through continual purchases of dollars with its foreign exchange reserves. Second, government can influence the exchange rate by using monetary policy to change the real interest rate; changes in the interest rate in turn affect capital inflows and outflows and thus the exchange rate. Most governments, through their central banks, adopt a combination of these two policies. | | | | |
