| | | | | | 16.7
Sterilization Policy | | | | | | | | | Monetary policy in the context of a fixed exchange rate is ineffective because an expansionary monetary policy creates a balance of payments deficit, which automatically decreases the money supply, offsetting and eventually eliminating the original increase in the money supply. What if, however, the monetary authorities take monetary action to counteract the automatic change in the money supply, allowing the original monetary dose to be maintained? As the money supply decreases automatically in the preceding example, the monetary authorities could annually increase the money supply by exactly the same amount. | | | | | | | | | This policy is called a sterilization policy because it "sterilizes" the automatic money-supply change that results from an imbalance in international payments under fixed exchange rates. Pursuing this policy maintains the original monetary policy dose and allows monetary policy to retain its effectiveness. | | | | | | | | | Unfortunately, there is a catch: the sterilization policy maintains the imbalance in international payments. In the example, the balance of payments deficit, which would normally disappear as it automatically decreased the money supply, now persists as this automatic mechanism is "sterilized." What are the implications of of a continuing balance of payments deficit? | | | | | | | | | Consider how the government, through its agent the central bank, deals with the balance of payments deficit. The deficit means that the supply of dollars on the foreign exchange market exceeds the demand, so those unable to obtain foreign exchange for their dollars go to the government to exchange them at the fixed rate. The government sells foreign currency to them at | | | | | | | | | | Curiosity 16.2: What Is the J Curve? | | | | | | | | | | Demand is always less sensitive to price changes in the short run than in the long run, when there is sufficient time for people to acquire information, change habits, and renegotiate contracts. Consequently, when the exchange rate falls, although imports are more expensive and exports less expensive, in the short run (six months to a year) the volume of imports and exports won't change much. If the volume of imports doesn't change much, but they are more expensive, the value of imports increases. And if the volume of exports doesn't change much, but they are less expensive, the value of exports falls. These effects push the economy to a balance of trade deficit, not the surplus we had claimed. In the short run, instead of improving the balance of payments, a devaluation worsens it. | | | | | | | | | | Fortunately, in the long run volumes do change by enough to improve the balance of trade. A graph of the balance of trade over time would show an initial fall toward a deficit, but eventually a rise toward a surplus. These values trace out a path that looks like the letter J and is accordingly called the J curve. This short-run reaction captured by the J curve is very frustrating for policy-makers because the economy initially goes in the wrong direction, creating great uncertainty. | | | | | |
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