Assuming perfect asset substitutability, can sterilized intervention by the central bank be effective? Please discuss
What will be an ideal response?
No, a sterilized foreign exchange intervention by the central bank leaves the domestic money supply unchanged. Under floating exchange rates, a change in the interest rate is needed to affect the exchange rate, but the interest rate won't change if the money supply does not. Under a fixed exchange rate, an expansive policy needs to be offset by an increase in the domestic money supply. To avoid inflation, the central bank sterilizes this increase in the money supply by selling domestic assets. However, with a fixed exchange rate, this means buying foreign assets. If foreign assets are perfect substitutes for domestic assets, this sterilization is not effective.
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