Chapter 21 Policy Effects with Floating Exchange Rates

Results

Using the AA-DD model, several important relationships between key economic variables are shown:

• Expansionary monetary policyAn increase in the money supply in a country. (↑M^S) causes an increase in GNP and a depreciation of the domestic currency in a floating exchange rate systemAn exchange rate system in which the value of a country’s currency is determined by the supply and demand for one currency in exchange for another in a private market operated by major international banks. in the short run.
• Contractionary monetary policyA decrease in the money supply in a country. (↓M^S) causes a decrease in GNP and an appreciation of the domestic currency in a floating exchange rate system in the short run.
• Expansionary fiscal policyAn increase in government spending or transfer payments and/or a decrease in tax revenues. (↑G, ↑TR, or ↓T) causes an increase in GNP and an appreciation of the domestic currency in a floating exchange rate system.
• Contractionary fiscal policyA decrease in government spending or transfer payments and/or an increase in tax revenues. (↓G, ↓TR, or ↑T) causes a decrease in GNP and a depreciation of the domestic currency in a floating exchange rate system.
• In the long run, once inflation effects are included, expansionary monetary policy (↑M^S) in a full employment economy causes no long-term change in GNP and a depreciation of the domestic currency in a floating exchange rate system. In the transition, the exchange rate overshoots its long-run target and GNP rises then falls.
• A sterilized foreign exchange interventionOccurs when a central bank counters direct intervention in the Forex with a simultaneous offsetting transaction in the domestic bond market. will have no effect on GNP or the exchange rate in the AA-DD model, unless international investors adjust their expected future exchange rate in response.
• A central bank can influence the exchange rate with direct Forex interventions (buying or selling domestic currency in exchange for foreign currency). To sell foreign currency and buy domestic currency, the central bank must have a stockpile of foreign currency reserves.
• A central bank can also influence the exchange rate with indirect open market operations (buying or selling domestic treasury bonds). These transactions work through money supply changes and their effect on interest rates.
• Purchases (sales) of foreign currency on the Forex will raise (lower) the domestic money supply and cause a secondary indirect effect upon the exchange rate.

Connections

The AA-DD model was developed to describe the interrelationships of macroeconomic variables within an open economy. Since some of these macroeconomic variables are controlled by the government, we can use the model to understand the likely effects of government policy changes. The two main levers the government controls are monetary policy (changes in the money supply) and fiscal policy (changes in the government budget). In this chapter, the AA-DD model is applied to understand government policy effects in the context of a floating exchange rate system. In Chapter 23 "Policy Effects with Fixed Exchange Rates", we’ll revisit these same government policies in the context of a fixed exchange rate system.

It is important to recognize that these results are what “would” happen under the full set of assumptions that describe the AA-DD model. These effects may or may not happen in reality. Despite this problem, the model surely captures some of the simple cause-and-effect relationships and therefore helps us to understand the broader implications of policy changes. Thus even if in reality many more elements not described in the model may act to influence the key endogenous variables, the AA-DD model at least gives a more complete picture of some of the expected tendencies.

Expansionary Monetary Policy

Suppose the economy is originally at a superequilibrium shown as point F in Figure 21.1 "Expansionary Monetary Policy in the AA-DD Model with Floating Exchange Rates". The original GNP level is Y¹ and the exchange rate is E_$/£¹. Next, suppose the U.S. central bank (or the Fed) decides to expand the money supply. As shown in Chapter 20 "The AA-DD Model", Section 20.5 "Shifting the AA Curve", money supply changes cause a shift in the AA curve. More specifically, an increase in the money supply will cause AA to shift upward (i.e., ↑M^S is an AA up-shifter). This is depicted in the diagram as a shift from the red AA to the blue A′A′ line.

There are several different levels of detail that can be provided to describe the effects of this policy. Below, we present three descriptions with increasing degrees of completeness. First the quick result, then the quick result with the transition process described, and finally the complete adjustment story.

Quick Result

The increase in AA causes a shift in the superequilibrium point from F to H. In adjusting to the new equilibrium at H, GNP rises from Y¹ to Y² and the exchange rate increases from E_$/£¹ to E_$/£². The increase in the exchange rate represents an increase in the British pound value and a decrease in the U.S. dollar value. In other words, it is an appreciation of the pound and a depreciation of the dollar. Since the final equilibrium point H is above the initial iso-CAB line CC, the current account balance increases. (See Chapter 20 "The AA-DD Model", Section 20.8 "AA-DD and the Current Account Balance" for a description of CC.) If the CAB were in surplus at F, then the surplus increases; if the CAB were in deficit, then the deficit falls. Thus U.S. expansionary monetary policy causes an increase in GNP, a depreciation of the U.S. dollar, and an increase in the current account balance in a floating exchange rate system according to the AA-DD model.

Transition Description

Consider the upward shift of the AA curve due to the increase in the money supply. Since exchange rates adjust much more rapidly than GNP, the economy will initially adjust back to the new A′A′ curve before any change in GNP occurs. That means the first adjustment will be from point F to point G directly above. The exchange rate will increase from E_$/£¹ to E_$/£¹′, representing a depreciation of the U.S. dollar.

Now at point G, the economy lies to the left of the DD curve. Thus GNP will begin to rise to get back to goods and services (G&S) market equilibrium on the DD curve. However, as GNP rises, the economy moves to the right above the A′A′ curve, which forces a downward readjustment of the exchange rate to get back to A′A′. In the end, the economy will adjust in a stepwise fashion from point G to point H, with each rightward movement in GNP followed by a quick reduction in the exchange rate to remain on the A′A′ curve. This process will continue until the economy reaches the superequilibrium at point H.

Notice that in the transition the exchange rate first rises to E_$/£¹′. Above the rate it will ultimately reach E_$/£² before settling back to superequilibrium value. This is an example of exchange rate overshooting. In the transition, the exchange rate overshoots its ultimate long-run value.

Exchange rate overshootingOccurs when an exchange rate, in the process of adjusting to a new equilibrium, either rises above the final equilibrium value before falling back again, or falls below the final equilibrium value before rising up again. is used as one explanation for the volatility of exchange rates in floating markets. If many small changes occur frequently in an economy, the economy may always be in transition moving to a superequilibrium. Because of the more rapid adjustment of exchange rates, it is possible that many episodes of overshooting—both upward and downward—can occur in a relatively short period.

Complete Adjustment Story

Step 1: When the money supply increases, real money supply will exceed real money demand in the economy. Since households and businesses hold more money than they would like, at current interest rates, they begin to convert liquid money assets into less-liquid nonmoney assets. This raises the supply of long-term deposits and the amount of funds available for banks to loan. More money to lend will lower average U.S. interest rates, which in turn will result in a lower U.S. rate of return in the Forex market. Since RoR_$ < ROR_£ now, there will be an immediate increase in the demand for foreign British currency, thus causing an appreciation of the pound and a depreciation of the U.S. dollar. Thus the exchange rate (E_$/£) rises. This change is represented by the movement from point F to G on the AA-DD diagram. The AA curve has shifted up to reflect the new set of asset market equilbria corresponding to the higher U.S. money supply. Since the money market and foreign exchange (Forex) markets adjust very swiftly to the money supply change, the economy will not remain off the new A′A′ curve for very long.

Step 2: Now that the exchange rate has risen to E_$/£¹′, the real exchange has also increased. This implies foreign goods and services are relatively more expensive while U.S. G&S are relatively cheaper. This will raise demand for U.S. exports, curtail demand for U.S. imports, and result in an increase in current account and, thereby, aggregate demand. Because aggregate demand exceeds aggregate supply, inventories will begin to fall, stimulating an increase in production and thus GNP. This is represented by a rightward shift from point G.

Step 3: As GNP rises, so does real money demand, causing an increase in U.S. interest rates. With higher interest rates, the rate of return on U.S. assets rises above that in the United Kingdom, and international investors shift funds back to the United States, resulting in a dollar appreciation (pound depreciation)—that is, a decrease in the exchange rate (E_$/£). This moves the economy downward, back to the A′A′ curve. The adjustment in the asset market will occur quickly after the change in interest rates. Thus the rightward shift from point G in the diagram results in quick downward adjustment to regain equilibrium in the asset market on the A′A′ curve, as shown in the figure.

Step 4: Continuing increases in GNP caused by excess aggregate demand, results in continuing increases in U.S. interest rates and rates of return, repeating the stepwise process above until the new equilibrium is reached at point H in the diagram.

Step 5: The equilibrium at H lies to the northeast of F along the original DD curve. As shown in Chapter 20 "The AA-DD Model", Section 20.8 "AA-DD and the Current Account Balance", the equilibrium at H lies above the original iso-CAB line. Therefore, the current account balance will rise.

Contractionary Monetary Policy

Contractionary monetary policy corresponds to a decrease in the money supply. In the AA-DD model, a decrease in the money supply shifts the AA curve downward. The effects will be the opposite of those described above for expansionary monetary policy. A complete description is left for the reader as an exercise.

The quick effects, however, are as follows. U.S. contractionary monetary policy will cause a reduction in GNP and a reduction in the exchange rate, E_$/£, implying an appreciation of the U.S. dollar and a decrease in the current account balance.

Expansionary Fiscal Policy

Suppose the economy is originally at a superequilibrium shown as point J in Figure 21.2 "Expansionary Fiscal Policy in the AA-DD Model with Floating Exchange Rates". The original gross national product (GNP) level is Y¹ and the exchange rate is E_$/£¹. Next, suppose the government decides to increase government spending (or increase transfer payments or decrease taxes). As shown in Chapter 20 "The AA-DD Model", Section 20.3 "Shifting the DD Curve", fiscal policy changes cause a shift in the DD curve. More specifically, an increase in government spending (or an increase in transfer payments or a decrease in taxes) will cause DD to shift rightward (i.e., ↑G, ↑TR, and ↓T all are DD right-shifters). This is depicted in the diagram as a shift from the red DD to the blue D′D′ line.

There are several different levels of detail that can be provided to describe the effects of this policy. Below, we present three descriptions with increasing degrees of completeness: first the quick result, then the quick result with the transition process described, and finally the complete adjustment story.

Quick Result

The increase in DD causes a shift in the superequilibrium point from J to K. In adjusting to the new equilibrium at K, GNP rises from Y¹ to Y² and the exchange rate decreases from E_$/£¹ to E_$/£². The decrease in the exchange represents a decrease in the British pound value and an increase in the U.S. dollar value. In other words, it is a depreciation of the pound and an appreciation of the dollar. Since the final equilibrium point K is below the initial iso-CAB line CC, the current account balance decreases. (Caveat: this will be true for all fiscal expansions, but the iso-CAB line can only be used with an increase in G; see Chapter 20 "The AA-DD Model", Section 20.8 "AA-DD and the Current Account Balance" for an explanation.) If the CAB were in surplus at J, then the surplus decreases; if the CAB were in deficit, then the deficit rises. Thus the U.S. expansionary fiscal policy causes an increase in the U.S. GNP, an appreciation of the U.S. dollar, and a decrease in the current account balance in a floating exchange rate system according to the AA-DD model.

Transition Description

If the expansionary fiscal policy occurs because of an increase in government spending, then government demand for goods and services (G&S) will increase. If the expansionary fiscal policy occurs due to an increase in transfer payments or a decrease in taxes, then disposable income will increase, leading to an increase in consumption demand. In either case aggregate demand increases, and this causes the rightward shift in the DD curve. Immediately after aggregate demand increases, but before any adjustment has occurred at point J, the economy lies to the left of the new D´D´ curve. Thus GNP will begin to rise to get back to G&S market equilibrium on the D´D´ curve. However, as GNP rises, the economy will move above the AA curve, forcing a downward readjustment of the exchange rate to get back to asset market equilibrium on the AA curve. In the end, the economy will adjust in a stepwise fashion from point J to point K, with each rightward movement in GNP followed by a quick reduction in the exchange rate to remain on the AA curve. This process will continue until the economy reaches the superequilibrium at point K.

Complete Adjustment Story

Step 1: If the expansionary fiscal policy occurs because of an increase in government spending, then government demand for G&S will increase. If the expansionary fiscal policy occurs due to an increase in transfer payments or a decrease in taxes, then disposable income will increase, leading to an increase in consumption demand. In either case aggregate demand increases. Before any adjustment occurs, the increase in aggregate demand implies aggregate demand exceeds aggregate supply, which will lead to a decline in inventories. To prevent this decline, retailers (or government suppliers) will signal firms to produce more. As supply increases so does the GNP, and the economy moves to the right of point J.

Step 2: As GNP rises, so does real money demand, causing an increase in U.S. interest rates. With higher interest rates, the rate of return on U.S. assets rises above that in the United Kingdom and international investors shift funds back to the United States, resulting in a dollar appreciation (pound depreciation)—that is, a decrease in the exchange rate E_$/£. This moves the economy downward, back to the AA curve. The adjustment in the asset market will occur quickly after the change in interest rates. Thus the rightward shift from point J in the diagram results in quick downward adjustment to regain equilibrium in the asset market on the AA curve, as shown.

Step 3: Continuing increases in GNP caused by excess aggregate demand, results in continuing increases in U.S. interest rates and rates of return, repeating the stepwise process above until the new equilibrium is reached at point K in the diagram.

Step 4: The equilibrium at K lies to the southeast of J along the original AA curve. As shown in Chapter 20 "The AA-DD Model", Section 20.8 "AA-DD and the Current Account Balance", the current account balance must be lower at K since both an increase in GNP and a dollar appreciation cause decreases in current account demand. Thus the equilibrium at K lies below the original iso-CAB line. However, this is only assured if the fiscal expansion occurred due to an increase in G.

If transfer payments increased or taxes were reduced, these would both increase disposable income and lead to a further decline in the current account balance. Thus also with these types of fiscal expansions, the current account balance is reduced; however, one cannot use the iso-CAB line to show it.

Contractionary Fiscal Policy

Contractionary fiscal policy corresponds to a decrease in government spending, a decrease in transfer payments, or an increase in taxes. It would also be represented by a decrease in the government budget deficit or an increase in the budget surplus. In the AA-DD model, a contractionary fiscal policy shifts the DD curve leftward. The effects will be the opposite of those described above for expansionary fiscal policy. A complete description is left for the reader as an exercise.

The quick effects, however, are as follows. U.S. contractionary fiscal policy will cause a reduction in GNP and an increase in the exchange rate (E_$/£), implying a depreciation of the U.S. dollar.

Partial Detail

The increase in the money supply causes the first upward shift of the AA curve, shown as step 1 in the diagram. Since exchange rates adjust much more rapidly than gross national product (GNP), the economy will quickly adjust to the new A′A′ curve before any change in GNP occurs. That means the first adjustment will be from point F to point G directly above. The exchange rate will increase from E¹ to E², representing a depreciation of the U.S. dollar.

The second effect is caused by changes in investor expectations. Investors generally track important changes in the economy, including money supply changes, because these changes can have important implications for the returns on their investments. Investors who see an increase in money supply in an economy at full employment are likely to expect inflation to occur in the future. When investors expect future U.S. inflation, and when they consider both domestic and foreign investments, they will respond today with an increase in their expected future exchange rate (E_$/£^e). There are two reasons to expect this immediate effect:

1. Investors are very likely to understand the story we are in the process of explaining now. As we will see below, the long-run effect of a money supply increase for an economy (initially, at full employment) is an increase in the exchange rate (E_$/£)—that is, a depreciation of the dollar. If investors believe the exchange rate will be higher next year due to today’s action by the Fed, then it makes sense for them to raise their expected future exchange rate in anticipation of that effect. Thus the average E_$/£^e will rise among investors who participate in the foreign exchange (Forex) markets.
2. Investors may look to the purchasing power parity (PPP) theory for guidance. PPP is generally interpreted as a long-run theory of exchange rate trends. If PPP holds in the long run, then E_$/£ = P_$/P_£. In other words, the exchange rate will equal the ratio of the two countries’ price levels. If P_$ is expected to rise due to inflation, then PPP predicts that the exchange rate (E_$/£) will also rise and the dollar will depreciate.

The timing of the change in E_$/£^e will depend on how quickly investors recognize the money supply change, compute its likely effect, and incorporate it into their investment plans. Since investors are typically very quick to adapt to market changes, the expectations effect should take place in the short run, perhaps long before the inflation ever occurs. In some cases, the expectations change may even occur before the Fed increases the money supply, if investors anticipate the Fed’s action.

The increase in the expected exchange rate (this means a decrease in the expected future dollar value) causes a second upward shift of the AA curve, shown as step 2 in the diagram. Again, rapid exchange rate adjustment implies the economy will quickly adjust to the new A″A″ curve at point H directly above. The exchange rate will now increase from E² to E³, representing a further depreciation of the U.S. dollar.

Once at point H, aggregate demand, which is on the DD curve to the right of H, exceeds aggregate supply, which is still at Y^F. Thus GNP will begin to rise to get back to G&S market equilibrium on the DD curve. However, as GNP rises, the economy moves above the A″A″ curve that forces a downward readjustment of the exchange rate to get back to asset market equilibrium on A″A″. In the end, the economy will adjust in a stepwise fashion from point H to point I, with each rightward movement in GNP followed by a quick reduction in the exchange rate to remain on the A″A″ curve. This process will continue until the economy reaches the temporary superequilibrium at point I.

The next effect occurs because GNP, now at Y² at point I, has risen above the full employment level at Y^F. This causes an increase in U.S. prices, meaning that P_$ (the U.S. price level) begins to rise. The increase in U.S. prices has two effects as shown in Figure 21.4 "Expansionary Monetary Policy in the Long Run, Continued". An increase in P_$ is both a DD left-shifter and an AA down-shifter.

In step 3, we depict a leftward shift of DD to D′D′. DD shifts left because higher U.S. prices will reduce the real exchange rate. This makes U.S. G&S relatively more expensive compared with foreign G&S, thus reducing export demand, increasing import demand, and thereby reducing aggregate demand.

In step 4, we depict a downward shift of A″A″ to A′″A′″. AA shifts down because a higher U.S. price level reduces real money supply. As the real money supply falls, U.S. interest rates rise, leading to an increase in the rate of return for U.S. assets as considered by international investors. This in turn raises the demand for U.S. dollars on the Forex, leading to a dollar appreciation. Since this effect occurs for any GNP level, the entire AA curve shifts downward.

Steps 3 and 4 will both occur simultaneously, and since both are affected by the increase in the price level, it is impossible to know which curve will shift faster or precisely how far each curve will shift. However, we do know two things. First, the AA and DD shifting will continue as long as GNP remains above the full employment level. Once GNP falls to Y_F, there is no longer upward pressure on the price level and the shifting will cease. Second, the final equilibrium exchange rate must lie above the original exchange rate. This occurs because output will revert back to its original level, the price level will be higher, and according to PPP, eventually the exchange rate will have to be higher as well.

The final equilibrium will be at a point like J, which lies to the left of I. In this transition, the exchange rate will occasionally rise when DD shifts left and will occasionally fall when AA shifts down. Thus the economy will wiggle its way up and down, from point I to J. Once at point J, there is no reason for prices to rise further and no reason for a change in investor expectations. The economy will have reached its long-run equilibrium.

Note that one cannot use the iso-CAB line to assess the long-run effect on the current account balance. In the final adjustment, although the final equilibrium lies above the original iso-CAB line, in the long run the P_$ changes will raise the iso-CAB lines, making it impossible to use these to identify the final effect.

However, in adjusting to the long-run equilibrium, the only two variables affecting the current account that will ultimately change are the exchange rate and the price level. If these two rise proportionally to each other, as they would if purchasing power parity held, then there will be no long-run effect on the current account balance.

The final long-run effect of an increase in the U.S. money supply in a floating exchange rate system is a depreciation of the U.S. dollar and no change in real GNP. Along the way, GNP temporarily rises and unemployment falls below the natural rate. However, this spurs an increase in the price level, which reduces GNP to its full employment level and raises unemployment back to its natural rate. U.S. inflation occurs in the transition while the price level is increasing.

Indirect Forex Intervention

The central bank can use an indirect method to raise or lower the exchange rate through domestic money supply changes. As was shown in Chapter 21 "Policy Effects with Floating Exchange Rates", Section 21.2 "Monetary Policy with Floating Exchange Rates", increases in the domestic U.S. money supply will cause an increase in E_$/£, or a dollar depreciation. Similarly, a decrease in the money supply will cause a dollar appreciation.

Despite relatively quick adjustments in assets markets, this type of intervention must traverse from open market operations to changes in domestic money supply, domestic interest rates, and exchange rates due to new rates of returns. Thus this method may take several weeks or more for the effect on exchange rates to be realized.

A second problem with this method is that to affect the exchange rate the central bank must change the domestic interest rate. Most of the time, central banks use interest rates to maintain stability in domestic markets. If the domestic economy is growing rapidly and inflation is beginning to rise, the central bank may lower the money supply to raise interest rates and help slow down the economy. If the economy is growing too slowly, the central bank may raise the money supply to lower interest rates and help spur domestic expansion. Thus to change the exchange rate using the indirect method, the central bank may need to change interest rates away from what it views as appropriate for domestic concerns at the moment. (Below we’ll discuss the method central banks use to avoid this dilemma.)

Direct Forex Intervention

The most obvious and direct way for central banks to intervene and affect the exchange rate is to enter the private Forex market directly by buying or selling domestic currency. There are two possible transactions.

First, the central bank can sell domestic currency (let’s use dollars) in exchange for a foreign currency (say, pounds). This transaction will raise the supply of dollars on the Forex (also raising the demand for pounds), causing a reduction in the value of the dollar and thus a dollar depreciation. Of course, when the dollar depreciates in value, the pound appreciates in value with respect to the dollar. Since the central bank is the ultimate source of all dollars (it can effectively print an unlimited amount), it can flood the Forex market with as many dollars as it desires. Thus the central bank’s power to reduce the dollar value by direct intervention in the Forex is virtually unlimited.

If instead, the central bank wishes to raise the value of the dollar, it will have to reverse the transaction described above. Instead of selling dollars, it will need to buy dollars in exchange for pounds. The increased demand for dollars on the Forex by the central bank will raise the value of the dollar, thus causing a dollar appreciation. At the same time, the increased supply of pounds on the Forex explains why the pound will depreciate with respect to the dollar.

The ability of a central bank to raise the value of its currency through direct Forex interventions is limited, however. In order for the U.S. Federal Reserve Bank (or the Fed) to buy dollars in exchange for pounds, it must have a stockpile of pound currency (or other pound assets) available to exchange. Such holdings of foreign assets by a central bank are called foreign exchange reservesHoldings of foreign assets by a country’s central bank. Usually held in the form of foreign government Treasury bonds.. Foreign exchange reserves are typically accumulated over time and held in case an intervention is desired. In the end, the degree to which the Fed can raise the dollar value with respect to the pound through direct Forex intervention will depend on the size of its pound denominated foreign exchange reserves.

Sterilized Forex Interventions

There are many times in which a central bank either wants or is pressured to affect the exchange rate value by intervening directly in the foreign exchange market. However, as shown above, direct Forex interventions will change the domestic money supply. A change in the money supply will affect the average interest rate in the short run and the price level, and hence the inflation rate, in the long run. Because central banks are generally entrusted to maintain domestic price stability or to assist in maintaining appropriate interest rates, a low unemployment rate, and GDP growth, Forex intervention will often interfere with one or more of their other goals.

For example, if the central bank believes that current interest rates should be raised slowly during the next several months to slow the growth of the economy and prevent a resurgence of inflation, then a Forex intervention to lower the value of the domestic currency would result in increases in the money supply and a decrease in interest rates, precisely the opposite of what the central bank wants to achieve. Conflicts such as this one are typical and usually result in a central bank choosing to sterilize its Forex interventions.

The intended purpose of a sterilized intervention is to cause a change in the exchange rate while at the same time leaving the money supply and hence interest rates unaffected. As we will see, the intended purpose is unlikely to be realized in practice.

A sterilized foreign exchange intervention occurs when a central bank counters direct intervention in the Forex with a simultaneous offsetting transaction in the domestic bond market. For example, suppose the U.S. Fed decides to intervene to lower the value of the U.S. dollar. This would require the Fed to sell dollars and buy foreign currency on the Forex. Sterilization, in this case, involves a Fed open market operation in which it sells Treasury bonds (T-bonds) at the same time and in the same value as the dollar sale in the Forex market. For example, if the Fed intervenes and sells $10 million on the Forex, sterilization means it will also sell $10 million of Treasury bonds on the domestic open market at the same time.

Consider the effects of a sterilized Forex intervention by the U.S. Fed shown in the adjoining AA-DD diagram, Figure 21.5 "Sterilization in the AA-DD Model". Suppose the economy is initially in equilibrium at point F with GDP (Y¹) and exchange rate (E_$/£¹). Now, suppose the Fed intervenes in the Forex by selling dollars and buying British pounds. The direct effect on the exchange rate is not represented in the AA-DD diagram. The only way it can have an effect is through the increase in the money supply, which will shift the AA curve up from AA to A′A′. However, sterilization means the Fed will simultaneously conduct an offsetting open market operation, in this case selling Treasury bonds equal in value to the Forex sales. The sale of T-bonds will lower the U.S. money supply, causing an immediate shift of the AA curve back from A′A′ to AA. In fact, because the two actions take place on the same day or within the same week at least, the AA curve does not really shift out at all. Instead, a sterilized Forex intervention maintains the U.S. money supply and thus achieves the Fed’s objective of maintaining interest rates.

However, because there is no shift in the AA or DD curves, the equilibrium in the economy will never move away from point F. This implies that a sterilized Forex intervention not only will not affect GNP, but also will not affect the exchange rate. This suggests the impossibility of the Fed’s overall objective to lower the dollar value while maintaining interest rates.

Empirical studies of the effects of sterilized Forex interventions tend to support the results of this simple model. In other words, real-world sterilizations have generally been ineffective in achieving any lasting effect upon a country’s currency value.

However, there are several reasons why sterilized interventions may be somewhat effective nonetheless. Temporary effects are certainly possible. If a central bank makes a substantial intervention in the Forex over a short period, this will certainly change the supply or demand of currency and have an immediate effect on the exchange rate on those days.

A more lasting impact can occur if the intervention leads investors to change their expectations about the future. This could happen if investors are not sure whether the central bank is sterilizing its interventions. Knowing that sterilization is occurring would require a careful observation of several markets unless the Fed announces its policy. However, rather than announcing a sterilized intervention, a central bank that wants to affect expectations should announce the Forex intervention while hiding its offsetting open market operation. In this way, investors may be fooled into thinking that the Forex intervention will lower the future dollar value and thus may adjust their expectations.

If investors are fooled, they will raise E_$/£^e in anticipation of the future dollar depreciation. The increase in E_$/£^e will shift the AA curve upward, resulting in an increase in GNP and a depreciation of the dollar. In this way, sterilized interventions may have a more lasting effect on the exchange rate. However, the magnitude of the exchange rate change in this case—if it occurs—will certainly be less than that achieved with a nonsterilized intervention.