Open economies Open economies in PK theoryin PK theory

Mundell-Fleming vsMundell-Fleming vs

Compensation and Compensation and sterilizationsterilization

OutlineOutline

► Balance sheets of central banks (Overdraft Balance sheets of central banks (Overdraft vs asset-based economies)vs asset-based economies)

► The Mundell-Fleming neoclassical point of The Mundell-Fleming neoclassical point of view of fixed exchange ratesview of fixed exchange rates

► The compensation thesis or endogenous The compensation thesis or endogenous sterilizationsterilization

► Balance sheets reconsideredBalance sheets reconsidered► The compensation thesis within the The compensation thesis within the

Canadian LVTSCanadian LVTS► China’s more recent exampleChina’s more recent example

The neoclassical balance sheet The neoclassical balance sheet of central banksof central banks

AssetsAssets LiabilitiesLiabilities

Foreign reservesForeign reserves Banknotes (cash) Banknotes (cash)

++

Bank reserves =Bank reserves =High powered money M0High powered money M0

Monetary baseMonetary baseGovernment securitiesGovernment securities

(claims on domestic (claims on domestic government)government)

Mundell-Fleming modelMundell-Fleming model

► The short-run neoclassical model is The short-run neoclassical model is essentially the Mundell-Fleming model (the essentially the Mundell-Fleming model (the IS/LM/BP model). IS/LM/BP model).

► Being based on the neoclassical synthesis, it Being based on the neoclassical synthesis, it contains many Keynesian features. contains many Keynesian features.

► Its main assertion is that an economy Its main assertion is that an economy operating with fixed exchange rates would operating with fixed exchange rates would lose control of the money supply, and hence lose control of the money supply, and hence that monetary policy is ineffective. that monetary policy is ineffective.

► By contrast, with flexible exchange rates, an By contrast, with flexible exchange rates, an expansionary monetary policy could achieve expansionary monetary policy could achieve higher levels of output and employment.higher levels of output and employment.

The Mundell-Fleming stabilizing The Mundell-Fleming stabilizing mechanismmechanism

► Suppose a country has a balance of payment surplus.Suppose a country has a balance of payment surplus.► To keep its exchange rate fixed, the central bank To keep its exchange rate fixed, the central bank

needs to purchase foreign currency.needs to purchase foreign currency.► This means that the central bank is adding foreign This means that the central bank is adding foreign

reserves to its assets.reserves to its assets.► The increase in foreign reserves leads to an increase The increase in foreign reserves leads to an increase

in the monetary base (HPM)in the monetary base (HPM)► The increase in the monetary base leads to an The increase in the monetary base leads to an

increase in the money supply (and a fall in interest increase in the money supply (and a fall in interest rates).rates).

► This leads to an increase in nominal income (through This leads to an increase in nominal income (through quantities or prices). Net exports fall.quantities or prices). Net exports fall.

► The balance of payments goes back to zero.The balance of payments goes back to zero.

Implications for monetary Implications for monetary policypolicy

► Monetary policy with fixed exchange rates is powerless.Monetary policy with fixed exchange rates is powerless.► An expansionary monetary policy (a higher supply of high An expansionary monetary policy (a higher supply of high

powered money) drives interest rates below their world levels, powered money) drives interest rates below their world levels, and it increases output and imports. and it increases output and imports.

► Both of these effects drive the balance of payments into a Both of these effects drive the balance of payments into a deficit situation, thus leading to a reduction of the central deficit situation, thus leading to a reduction of the central bank foreign reserves, as the central bank attempts to sustain bank foreign reserves, as the central bank attempts to sustain the value of its domestic currency on exchange markets. the value of its domestic currency on exchange markets.

► The reduction in the foreign reserves diminishes the assets of The reduction in the foreign reserves diminishes the assets of the central bank, thus inducing a reduction in the monetary the central bank, thus inducing a reduction in the monetary base and hence in the money supply of the economy. base and hence in the money supply of the economy.

► The autonomous expansionary policy of the central bank is The autonomous expansionary policy of the central bank is thus counter-balanced by this thus counter-balanced by this endogenousendogenous reduction in the reduction in the monetary base and money supply. monetary base and money supply.

► The money supply is endogenous, but The money supply is endogenous, but supply-led.supply-led.► (in the PK view the money supply is endogenous, but (in the PK view the money supply is endogenous, but

demand-leddemand-led))

Mundell quoteMundell quote

► “…“…To prevent the exchange rate from falling To prevent the exchange rate from falling the central bank intervenes in the market, the central bank intervenes in the market, selling foreign exchange and buying selling foreign exchange and buying domestic money….[] Forcing the central domestic money….[] Forcing the central bank to intervene by buying foreign bank to intervene by buying foreign reserves and increasing the money supply.... reserves and increasing the money supply.... When the central bank buys or sells foreign When the central bank buys or sells foreign exchange the money supply increases or exchange the money supply increases or decreases”decreases”

► (Mundell, 1963, p. 479). (Mundell, 1963, p. 479).

More recent quoteMore recent quote

► ““But the main point is that, in behaving in this way, But the main point is that, in behaving in this way, the central bank loses control over the home the central bank loses control over the home country’s money stock. This is because each country’s money stock. This is because each exchange by the central bank of dollars for foreign exchange by the central bank of dollars for foreign currency has the effect of changing the home currency has the effect of changing the home country’s stock of ‘high-powered money’ country’s stock of ‘high-powered money’ (alternatively referred to as ‘base money’ or the (alternatively referred to as ‘base money’ or the ‘monetary base’). And as most readers will know ‘monetary base’). And as most readers will know from their study of money and banking, changes in from their study of money and banking, changes in high-powered money tend strongly to induce high-powered money tend strongly to induce changes – approximately equal percentage changes changes – approximately equal percentage changes – in the stock of money ....”– in the stock of money ....”

► (McCallum, 1996, p. 137)(McCallum, 1996, p. 137)

Quote continuesQuote continues

► ““Let us conclude this section by reiterating its Let us conclude this section by reiterating its central and fundamental message: in order to central and fundamental message: in order to maintain a fixed exchange rate, a central maintain a fixed exchange rate, a central bank must engage in foreign exchange bank must engage in foreign exchange transactions that prevent it from managing transactions that prevent it from managing the monetary base so as to achieve other the monetary base so as to achieve other macroeconomic objectives. If monetary policy macroeconomic objectives. If monetary policy is dedicated to pegging the exchange rate, it is dedicated to pegging the exchange rate, it is then unavailable (except on a highly is then unavailable (except on a highly temporary basis) for application to other temporary basis) for application to other goals.”goals.”

► (McCallum, 1996, pp. 139-140).(McCallum, 1996, pp. 139-140).

Hume’s specie flow Hume’s specie flow mechanismmechanism

► This mechanism is similar to Hume’s specie-flow This mechanism is similar to Hume’s specie-flow mechanism and related to the theory of mechanism and related to the theory of comparative advantage. A country with a balance comparative advantage. A country with a balance of payments deficit will suffer from an outflow of of payments deficit will suffer from an outflow of gold, which will induce a fall in its money supply, gold, which will induce a fall in its money supply, and this in turn will lead to a general fall in prices. and this in turn will lead to a general fall in prices. A general absolute disadvantage will be turned A general absolute disadvantage will be turned into a comparative advantage for some products. into a comparative advantage for some products.

► Similarly, the country with an absolute Similarly, the country with an absolute competitive advantage will show a balance of competitive advantage will show a balance of payments surplus, which will generate an inflow payments surplus, which will generate an inflow of gold and a continuous increase in the stock of of gold and a continuous increase in the stock of money and in prices, until the dearer prices bring money and in prices, until the dearer prices bring back to equilibrium the balance of payments.back to equilibrium the balance of payments.

The Rules of the gameThe Rules of the game

► A similar mechanism is provided by the modern A similar mechanism is provided by the modern “monetary approach to the balance of payments” “monetary approach to the balance of payments” of the monetarists, where full employment is of the monetarists, where full employment is explicitly assumed. Indeed, neoclassical explicitly assumed. Indeed, neoclassical economists claim that the economists claim that the Rules of the GameRules of the Game must be such that “a balance of payments deficit must be such that “a balance of payments deficit should be fully reflected in a reduction in the should be fully reflected in a reduction in the supply of money, and a surplus should be fully supply of money, and a surplus should be fully reflected in an increased money supply” (Ethier reflected in an increased money supply” (Ethier 1988: 341). 1988: 341).

► The balance of payments is The balance of payments is self-adjusting both self-adjusting both in fixed and flexible exchange rate regimesin fixed and flexible exchange rate regimes..

The rules of the game are not The rules of the game are not automaticautomatic

► Mundell (1961), whose other works are often Mundell (1961), whose other works are often invoked to justify the relevance of the rules of the invoked to justify the relevance of the rules of the game in textbooks and the IS/LM/BP model, was game in textbooks and the IS/LM/BP model, was himself aware that the automaticity of the himself aware that the automaticity of the rules of rules of the gamethe game relied on a particular behaviour of the relied on a particular behaviour of the central bank. central bank.

► Indeed he lamented over the fact that modern Indeed he lamented over the fact that modern central banks were following the central banks were following the banking principlebanking principle instead of the instead of the bullionist principlebullionist principle, and hence , and hence adjusting ‘the domestic supply of notes to accord adjusting ‘the domestic supply of notes to accord with the needs of trade’ (1961, p. 153), which is with the needs of trade’ (1961, p. 153), which is another way to say that the money supply was another way to say that the money supply was endogenous and that central banks were concerned endogenous and that central banks were concerned with maintaining the targeted interest rates. with maintaining the targeted interest rates.

Sterilization or neutralizationSterilization or neutralization

► Students are sometimes told that such a situation Students are sometimes told that such a situation need not occurred, however, if the impact of the need not occurred, however, if the impact of the deficit on official foreign reserves is being deficit on official foreign reserves is being neutralized neutralized or or sterilizedsterilized..

► In the case of the balance of payments deficit, this In the case of the balance of payments deficit, this would imply that monetary authorities retain would imply that monetary authorities retain control over the monetary base by engaging into control over the monetary base by engaging into counter-balancing open market operations, by counter-balancing open market operations, by purchasing government securities from the market. purchasing government securities from the market.

► These sterilization operations allow central banks to These sterilization operations allow central banks to keep their assets at a constant level, thus halting keep their assets at a constant level, thus halting any endogenous decrease in the money supply.any endogenous decrease in the money supply.

Can sterilization be pursued for long?Can sterilization be pursued for long?

► It is usually argued that sterilization cannot be It is usually argued that sterilization cannot be pursued for very long or is ineffective. pursued for very long or is ineffective.

► For Claassen (1996, p. 51) for instance, ‘in the For Claassen (1996, p. 51) for instance, ‘in the context of “perfect capital mobility” ... sterilized context of “perfect capital mobility” ... sterilized intervention policies are doomed to be intervention policies are doomed to be ineffective’. ineffective’.

► In our opinion, such statements confuse In our opinion, such statements confuse perfect perfect capital mobilitycapital mobility with with perfect asset perfect asset substitutabilitysubstitutability. .

► They also do not distinguish between countries They also do not distinguish between countries that are in a current account deficit situation and that are in a current account deficit situation and losing reserves (say some Latin American losing reserves (say some Latin American countries) and those that are in a surplus countries) and those that are in a surplus situation and gaining reserves (say China). situation and gaining reserves (say China).

The standard viewThe standard view► ““The effect on the stock of base money of a The effect on the stock of base money of a

purchase of foreign currency could be undone, for purchase of foreign currency could be undone, for example, by a sale by the central bank of example, by a sale by the central bank of government bonds. Such an action is termed a government bonds. Such an action is termed a sterilizationsterilization of the foreign exchange purchase, of the foreign exchange purchase, which becomes a which becomes a sterilized interventionsterilized intervention’. It is the ’. It is the case, then, that central bank interventions in the case, then, that central bank interventions in the foreign exchange market may not affect the foreign exchange market may not affect the home country money stock if they are sterilized. home country money stock if they are sterilized. Most research on this issue has indicated, Most research on this issue has indicated, however, that the effects on exchange rates of however, that the effects on exchange rates of sterilized market interventions are both weak and sterilized market interventions are both weak and short-lived. Thus a central bank can keep its short-lived. Thus a central bank can keep its nation’s exchange rate fixed only by engaging in nation’s exchange rate fixed only by engaging in non-sterilized interventions”.non-sterilized interventions”.

► (McCallum, 1996, p. 138)(McCallum, 1996, p. 138)

Another, new, argument against Another, new, argument against sterilizationsterilization

► In the context of Latin American countries, In the context of Latin American countries, Frenkel (2006, p. 587) writes that sterilization Frenkel (2006, p. 587) writes that sterilization operations:operations:

“ “consist in the selling of public-sector or consist in the selling of public-sector or central bank papers with the objective of central bank papers with the objective of money absorption. They imply a financial cost money absorption. They imply a financial cost to the treasury or the central bank, to the treasury or the central bank, proportional to the difference between the proportional to the difference between the interest rate of those papers and the interest interest rate of those papers and the interest rate earned by the central bank’s international rate earned by the central bank’s international reserves”. reserves”.

The opportunity cost of sterilization if The opportunity cost of sterilization if interest rates are high in the domestic interest rates are high in the domestic

economy economy (the case of a surplus economy)(the case of a surplus economy)

AssetsAssets LiabilitiesLiabilities

Foreign reserves (US Foreign reserves (US Treasury bills at 1%) Treasury bills at 1%) ↑↑

Banknotes (cash) Banknotes (cash)

++

Bank reserves =Bank reserves =High powered money M0High powered money M0

Monetary baseMonetary baseDomestic government Domestic government securities (at 5%) securities (at 5%) ↓↓

History shows that the rules of the game History shows that the rules of the game never held, even during the gold exchange never held, even during the gold exchange

regimeregime► Bloomfield (1959, p. 49) shows that when looking Bloomfield (1959, p. 49) shows that when looking

at year-to-year changes in the period before the at year-to-year changes in the period before the First World War – the heyday of the gold standard First World War – the heyday of the gold standard – the foreign assets and the domestic assets of – the foreign assets and the domestic assets of central banks moved in opposite directions 60% central banks moved in opposite directions 60% of the time. Foreign assets and domestic assets of the time. Foreign assets and domestic assets moved in the same direction only 34% of the time moved in the same direction only 34% of the time for the eleven central banks under consideration. for the eleven central banks under consideration.

► The prevalence of a negative correlation thus The prevalence of a negative correlation thus shows that the so-called Rules of the Game were shows that the so-called Rules of the Game were violated more often than not, even during the violated more often than not, even during the heyday of the gold standard. Indeed, ‘in the case heyday of the gold standard. Indeed, ‘in the case of of everyevery central bank the year-to-year changes in central bank the year-to-year changes in international and domestic assets were more international and domestic assets were more often in the often in the oppositeopposite than in the same direction’ than in the same direction’ (Bloomfield, 1959, pp. 49-50).(Bloomfield, 1959, pp. 49-50).

Further resultsFurther results► Almost identical results were obtained in the case Almost identical results were obtained in the case

of the 1922-1938 period. of the 1922-1938 period. ► Ragnar Nurkse (1944, p. 69) shows that the foreign Ragnar Nurkse (1944, p. 69) shows that the foreign

assets and the domestic assets of twenty-six assets and the domestic assets of twenty-six central banks moved in opposite direction in 60% of central banks moved in opposite direction in 60% of the years under consideration, and that they moved the years under consideration, and that they moved in the same direction only 32% of the time. in the same direction only 32% of the time.

► Studying the various episodes of inflows or outflows Studying the various episodes of inflows or outflows of gold and exchange reserves, Nurkse (1944, p. of gold and exchange reserves, Nurkse (1944, p. 88) concludes that ‘neutralization was the rule 88) concludes that ‘neutralization was the rule rather than the exception’. Without saying so, rather than the exception’. Without saying so, Nurkse adopts the compensation principle as the Nurkse adopts the compensation principle as the phenomenon ruling central banks in an open phenomenon ruling central banks in an open economy. The rules of the game as they were to be economy. The rules of the game as they were to be endorsed in the modern IS/LM/BP models of Mundell endorsed in the modern IS/LM/BP models of Mundell are an erroneous depiction of reality.are an erroneous depiction of reality.

The compensation thesisThe compensation thesis► Bloomfield and Nurkse have uncovered what was later to be Bloomfield and Nurkse have uncovered what was later to be

called the called the compensation thesis.compensation thesis.► The compensation thesis is sometimes called the The compensation thesis is sometimes called the Banque de Banque de

France viewFrance view, because in its modern incarnation it was , because in its modern incarnation it was endorsed by Pierre Berger, who was the general director of endorsed by Pierre Berger, who was the general director of research at the Banque de France. research at the Banque de France.

► Berger (1972a, p. 94, 1972b, p. 171), points out that the Berger (1972a, p. 94, 1972b, p. 171), points out that the compensation phenomenon that can be observed in modern compensation phenomenon that can be observed in modern economies could already be observed in the 19th century. economies could already be observed in the 19th century.

► Berger argues that when France had large external surpluses, Berger argues that when France had large external surpluses, and hence was accumulating gold reserves, the peaks in the and hence was accumulating gold reserves, the peaks in the gold reserves of the Banque de France were accompanied by gold reserves of the Banque de France were accompanied by throughs in credits to the domestic economy. throughs in credits to the domestic economy.

► As a result, despite the wide fluctuations in gold reserves, the As a result, despite the wide fluctuations in gold reserves, the variations in the monetary base and the money supply were variations in the monetary base and the money supply were quite limited.quite limited.

Nurkse and the compensation Nurkse and the compensation thesisthesis

► ““There is nothing automatic about the There is nothing automatic about the mechanism envisaged in the “rules of the mechanism envisaged in the “rules of the game”. We have seen that automatic forces, game”. We have seen that automatic forces, on the contrary, may make for neutralization. on the contrary, may make for neutralization. Accordingly, if central banks were to intensify Accordingly, if central banks were to intensify the effect of changes in their international the effect of changes in their international assets instead of offsetting them or allowing assets instead of offsetting them or allowing them to be offset by inverse changes in their them to be offset by inverse changes in their domestic assets, this would require not only domestic assets, this would require not only deliberate management but possibly even deliberate management but possibly even management in opposition to automatic management in opposition to automatic tendencies.”tendencies.”

► (Nurkse, 1944, p. 88)(Nurkse, 1944, p. 88)

Active sterilization or Active sterilization or passive compensation?passive compensation?

► Nurkse’s rejects the standard interpretation in terms Nurkse’s rejects the standard interpretation in terms of a ‘sterilization’ operation initiated by the central of a ‘sterilization’ operation initiated by the central bank. bank.

► Nurkse considers that it would be ‘quite wrong to Nurkse considers that it would be ‘quite wrong to interpret [the inverse correlation] as a deliberate act interpret [the inverse correlation] as a deliberate act of neutralization’ on the part of the central bank. of neutralization’ on the part of the central bank.

► On the opposite, Nurkse considers that the On the opposite, Nurkse considers that the neutralization of shifts in foreign reserves is caused neutralization of shifts in foreign reserves is caused by ‘normal’ or ‘automatic’ factors, and that the by ‘normal’ or ‘automatic’ factors, and that the compensation principle operates both in compensation principle operates both in overdraftoverdraft financial systems and in the financial systems and in the asset-basedasset-based ones. ones.

► In the overdraft system, Nurkse (1944, p. 70) notes In the overdraft system, Nurkse (1944, p. 70) notes that ‘an inflow of gold, for instance, tends to result in that ‘an inflow of gold, for instance, tends to result in increased liquidity on the domestic money market, increased liquidity on the domestic money market, which in turn may naturally lead the market to repay which in turn may naturally lead the market to repay some of its indebtedness to the central bank’.some of its indebtedness to the central bank’.

Active sterilization or Active sterilization or passive compensation? (2)passive compensation? (2)

► But Nurkse also observed compensating But Nurkse also observed compensating phenomena that were consistent with the phenomena that were consistent with the operation of an asset-based financial system. operation of an asset-based financial system.

► In the case of an inflow of gold and foreign In the case of an inflow of gold and foreign exchange, foreign investors (or the banks where exchange, foreign investors (or the banks where their deposits would be held) would purchase new their deposits would be held) would purchase new government securities. government securities.

► This would allow Government to reduce its debt This would allow Government to reduce its debt to the central bank, as would be the case in an to the central bank, as would be the case in an open-market operation.open-market operation.

► However, as Nurkse (1944, p. 77) points out, in However, as Nurkse (1944, p. 77) points out, in contrast to the usual open-market operation, the contrast to the usual open-market operation, the manoeuvre ‘did not come about at the Bank’s manoeuvre ‘did not come about at the Bank’s initiative’. initiative’.

► Alternatively, Nurkse (1944, p. 76) points out, Alternatively, Nurkse (1944, p. 76) points out, gold inflows could also be neutralized by an gold inflows could also be neutralized by an increase in government deposits held at the increase in government deposits held at the central bank, as the Bank of Canada used to do.central bank, as the Bank of Canada used to do.

Even Keynes recognized the Even Keynes recognized the compensation principlecompensation principle

► Keynes (1930, ch. 32) was also keenly aware of the Keynes (1930, ch. 32) was also keenly aware of the compensation phenomenon. compensation phenomenon.

► He points out that year after year the Bank of England He points out that year after year the Bank of England would gain £10,000,000 of gold in the spring and lose would gain £10,000,000 of gold in the spring and lose a similar amount in the autumn. This should have a similar amount in the autumn. This should have caused concern to all, but it did not, because these caused concern to all, but it did not, because these inflows and outflows were compensated by inflows and outflows were compensated by corresponding seasonal outflows and inflows arising corresponding seasonal outflows and inflows arising from the Treasury. from the Treasury.

► In the spring, with the receipts of income tax, the In the spring, with the receipts of income tax, the Treasury would buy back its securities from the public Treasury would buy back its securities from the public and from the Bank of England, thus reducing the and from the Bank of England, thus reducing the domestic credit entry in the balance sheet of the domestic credit entry in the balance sheet of the Bank of England.Bank of England.

A PK, more realistic, balance A PK, more realistic, balance sheet of central bankssheet of central banks

AssetsAssets LiabilitiesLiabilities

Foreign reservesForeign reserves BanknotesBanknotes

Bank deposits (bank Bank deposits (bank reserves)reserves)

Claims on domestic Claims on domestic government (Treasury government (Treasury bills)bills)

Government depositsGovernment deposits

Claims on domestic Claims on domestic banks (advances)banks (advances)

Central bank billsCentral bank bills

An obvious case of endogenous An obvious case of endogenous sterilization: Germanysterilization: Germany

Peoples’ Bank of China balance sheet (B of Peoples’ Bank of China balance sheet (B of yuan): yuan):

the role of central bank bonds and govt the role of central bank bonds and govt depositsdeposits

► June 1999June 1999 Nov. 2007Nov. 2007► AssetsAssets► Foreign assetsForeign assets 1,3881,388 12,21712,217► Claims on central governmentClaims on central government 158158 882882► Claims on banks Claims on banks 150150 2,2262,226► LiabilitiesLiabilities► Currency and bank reservesCurrency and bank reserves 3,0203,020 9,2439,243► Central government depositsCentral government deposits 33 2,3152,315► Central bank bondsCentral bank bonds 1212 3,5663,566► Foreign liabilitiesForeign liabilities 33 66► Others …Others …

► Table 4: The balance sheet of the People’s Bank of Table 4: The balance sheet of the People’s Bank of China, in 100 million RMBChina, in 100 million RMB

► December 1999November December 1999November 20072007Assets35349165299Assets35349165299Foreign Foreign assets14458122170Total Claims Claims on assets14458122170Total Claims Claims on government Claims on banks and other financial government Claims on banks and other financial institutions20337 1582 1920731412 8825 institutions20337 1582 1920731412 8825 2226022260Liabilities35349165299Liabilities35349165299Reserve Money Reserve Money Currency Deposit of financial33620 15069 Currency Deposit of financial33620 15069 1472892433 31389 60775Bond 1472892433 31389 60775Bond Issues11835667Deposits of Issues11835667Deposits of Government178523159Government178523159Source: People's Bank of Source: People's Bank of ChinaChina

The Canadian case, before The Canadian case, before giving up exchange rate giving up exchange rate

interventionsinterventions

The LVTSThe LVTS► In one of its background papers, the Bank of Canada (2003) In one of its background papers, the Bank of Canada (2003)

explains that when it conducts exchange rate operations, explains that when it conducts exchange rate operations, moderating a decline in the Canadian dollar for instance, it must moderating a decline in the Canadian dollar for instance, it must sterilize its purchases of Canadian dollars by ‘redepositing the sterilize its purchases of Canadian dollars by ‘redepositing the same amount of Canadian-dollar balances in the financial same amount of Canadian-dollar balances in the financial system’, in order ‘to make sure that the Bank’s purchases do not system’, in order ‘to make sure that the Bank’s purchases do not take money out of circulation and create a shortage of Canadian take money out of circulation and create a shortage of Canadian dollars, which could put upward pressures on Canadian interest dollars, which could put upward pressures on Canadian interest rates’. rates’.

► Similarly, when the Bank wishes to slow down the appreciation Similarly, when the Bank wishes to slow down the appreciation of the dollar and sells Canadian dollars on the exchange markets, of the dollar and sells Canadian dollars on the exchange markets, thus acquiring foreign currency, ‘to prevent downward pressure thus acquiring foreign currency, ‘to prevent downward pressure on Canadian interest rates ... the same amount of Canadian-dollar on Canadian interest rates ... the same amount of Canadian-dollar balances are withdrawn from the financial system.’. Thus balances are withdrawn from the financial system.’. Thus sterilization is not a matter of choice, it is a necessity as long as sterilization is not a matter of choice, it is a necessity as long as the central bank wants to keep the interest rate at its target level.the central bank wants to keep the interest rate at its target level.

Impact of foreign exchange intervention: central bank buys foreign currency (to stop CDN $ from rising)

Chartered bank (BMO)Chartered bank (BMO) LVTSLVTS

AssetsAssets LiabilitiesLiabilities AssetsAssets LiabilitiesLiabilities

LVTS balances LVTS balances + $60 M + $60 M

Deposits of Deposits of exporter exporter + $60 M + $60 M

LVTS balances of LVTS balances of BMO +$60 MBMO +$60 M

LVTS balances of LVTS balances of Bank of CanadaBank of Canada− − $60 M$60 M

Bank of Canada Bank of Canada

AssetsAssets Liabilities Liabilities LVTS balances − $60 MLVTS balances − $60 MForeign reserves +$60 MForeign reserves +$60 M

Impact of foreign exchange intervention: central bank needs to bring LVTS balances back to zero

Chartered bank (BMO)Chartered bank (BMO) LVTSLVTS

AssetsAssets LiabilitiesLiabilities AssetsAssets LiabilitiesLiabilities

LVTS balances LVTS balances + $60 M + $60 M

Deposits of Deposits of exporter exporter + $60 M + $60 M

LVTS balances of LVTS balances of BMO $0BMO $0

LVTS balances LVTS balances − − $60 M$60 M

Government Government deposits deposits

− − $60 M$60 M

LVTS balances of LVTS balances of Bank of CanadaBank of Canada $0$0

Bank of Canada Bank of Canada

AssetsAssets Liabilities Liabilities LVTS balances 0LVTS balances 0Foreign reserves +$60 MForeign reserves +$60 M

Government deposits +$60 MGovernment deposits +$60 M

Next week …Next week …

►A stock-flow consistent model of A stock-flow consistent model of endogenous sterilizationendogenous sterilization

►And a flexible exchange rate modelAnd a flexible exchange rate model