20 CHAPTER 1. SOME INSTITUTIONAL BACKGROUND

if the home country spends less abroad than it receives there will be a privately determined excess supply of foreign exchange. The central bank can absorb the excess supply by accumulating foreign exchange reserves. Changes in the central bank’s foreign exchange reserves are recorded in the o cial settlements balance, which we argued above is the balance of payments. Central bank foreign exchange reserve losses are credits and their reserve gains are debits to the o cial settlements account.

1.3The Central Bank’s Balance Sheet

The monetary liabilities of the central bank is called the monetary base, B. It is comprised of currency and commercial bank reserves or deposits at the central bank. The central bank’s assets can be classiÞed into two main categories. The Þrst is domestic credit, D. In the US, domestic credit is extended to the treasury when the central bank engages in open market operations and purchases US Treasury debt and to the commercial banking system through discount lending. The second asset category is the central bank’s net holdings of foreign assets, NFAcb. These are mainly foreign exchange reserves held by the central bank minus its domestic currency liabilities held by foreign central banks. Foreign exchange reserves include foreign currency, foreign government Treasury bills, and gold. We state the central bank’s balance sheet identity as

B = D + NFAcb.

(1.22)

Since the money supply varies in proportion to changes in the monetary base, you see from (1.22) that in the open economy there are two determinants of the money supply. The central bank can alter the money supply either through a change in discount lending, open market operations, or via foreign exchange intervention. Under a regime of perfectly ßexible exchange rates, ∆NFAcb = 0, which implies that, the central bank controls the money supply just as it does in the closed economy case.

1.3. THE CENTRAL BANK’S BALANCE SHEET

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Mechanics of Intervention

Suppose that the central bank wants to the dollar to fall in value against the yen. To achieve this result, it must buy yen which increases NFAcb, B, and hence the money supply M. If the Fed buys the yen from Citibank (say), in New York, the Fed pays for the yen by crediting Citibank’s reserve account. Citibank then transfers ownership of a yen deposit at a Japanese bank to the Fed.

If the intervention ends here the US money supply increases but the

Japanese money supply is una ected. In Japan, all that happens is a swap of deposit liabilities in the Japanese commercial bank. The Fed could go a step further and convert the deposit into Japanese T-bills. It might do so by buying T-bills from a Japanese resident which it pays for by writing a check drawn on the Japanese bank. The Japanese resident deposits that check in a bank, and still, there is no net e ect on the Japanese monetary base.

If, on the other hand, the Fed converts the deposit into currency, the Japanese monetary base does decline. The reason for this is that the Japanese monetary base is reduced when the Fed withdraws currency from circulation. The Fed would never do this, however, because currency pays no interest. The intervention described above is referred to as an unsterilized intervention because the central bank’s foreign exchange transactions have been allowed to a ect the domestic money supply. A sterilized intervention, on the other hand occurs when the central bank o sets its foreign exchange operations with transactions in domestic credit so that no net change in the money supply occurs. To sterilize the yen purchase described above, the Fed would simultaneously undertake an open market sale, so that D would decrease by exactly the amount that NFAcb increases from the foreign exchange intervention. It is an open question whether sterilized interventions can have a permanent e ect on the exchange rate.

22 CHAPTER 1. SOME INSTITUTIONAL BACKGROUND