Sterilization (economics)

In macroeconomics, sterilization is action taken by a country's central bank to counter the effects on the money supply caused by a balance of payments surplus or deficit. This can involve open market operations undertaken by the central bank whose aim is to neutralize the impact of associated foreign exchange operations. The opposite is unsterilized intervention, where monetary authorities have not insulated their country's domestic money supply and internal balance against foreign exchange intervention. Sterilization is most often used in the context of a central bank that takes actions to negate potentially harmful impacts of capital inflows – such as currency appreciation and inflation – both of which can reduce export competitiveness. More generally, it may refer to any form of monetary policy which seeks to hold the domestic money supply unchanged despite external shocks or other changes, including the flow of capital out of the relevant area (generally, a country). In the second half of the 20th century, sterilization was sometimes associated with efforts by monetary authorities to "defend" the value of their currency. In the 1930s and in the 21st century, sterilization has most commonly been associated with efforts by nations with a balance of payments surplus to prevent currency appreciation. Assume that a country's currency is depreciating. To prevent this, the country's central bank may decide to intervene in the foreign exchange market. To prop up the value of the nation's currency, the central bank may resort to creating artificial demand for its currency. It can do this by using some of its foreign exchange reserves to buy local currency. The resulting demand stops the currency's depreciation but also acts to reduce the domestic money supply in two ways. First the bank is directly removing some of the nation's currency from circulation as it buys it up. Secondly, if the central bank overshoots the target, the intervention can create or worsen a current account deficit due to the propped-up exchange rate being more favorable for importers than for exporters.