19.3 The Managed or Dirty Float #Notebook

19.3 The Managed or Dirty Float #Notebook

Under a managed float, the central bank allows market forces to determine second-to-second (day-to-day) fluctuations in exchange rates, but intervenes if the currency grows too weak or too strong, keeping the exchange rate range bound. 

Central banks intervene in the foreign exchange markets by exchanging international reserves, assets denominated in foreign currencies, gold, and special drawing rights, SDRs.

If a central bank selling $10 billion of international reserves, thereby soaking up $10 billion of the monetary base.

The Assets = International reserves −$10 billion

The Liabilities = Currency in circulation or reserves −$10 billion

*The money is going back to their source.

If a central bank buys $100 million of international reserves, both MB and its holdings of foreign assets would increase.

Its Assets = International reserves +$100 million

Its Liabilities = Monetary base +$100 million

*The money is flowing out of their source.

Such transactions are influencing the foreign exchange rate via changes in MB through the money supply (MS).

Central banks also engage in sterilized foreign exchange interventions when they offset the purchase or sale of international reserves with a domestic sale or purchase. 

A central bank might offset or sterilize the purchase of $100 million of international reserves by selling $100 million of domestic government bonds.

Its Assets = International reserves +$100 million, Monetary base +$100 million

Its Liabilities = Government bonds −$100 million, Monetary base −$100 million

*Here I have a question to ask, why the Government bonds are on the liabilities side if it is originally one of the assets holdings?

Why not like this?

Its Assets = International reserves +$100 million, Government bonds −$100 million

Its Liabilities = Monetary base +$100 million, Monetary base −$100 million

Since there is no net change in MB, a sterilized intervention should have no long-term impact on the exchange rate. It is for the short-term or for the signal of desire.

Central banks can use international reserves in a fruitless attempt to prevent a depreciation, or maintenance of the peg might require increasing or decreasing the MB counter to the needs of the domestic economy.

Reference

Wright, R.E. & Quadrini, V. (2009). Money and Banking. Saylor Foundation. Licensed under Creative Commons Attribution-NonCommercial-ShareAlike CC BY-NC-SA 3.0 license.