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.

[citation needed] 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.

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.

It can do this by engaging in open market operations that supply liquidity into the system, by buying financial assets such as local-currency-denominated bonds, using local currency as payment.

In practice, the cause driving sterilized interventions in the late 20th century was often that a high money supply had meant local interest rates were lower than they were internationally, creating the conditions for a carry trade.

[5] A central bank normally makes a small loss from its overall sterilization operations, as the interest it earns from buying foreign assets to prevent appreciation is usually less than what it has to pay out on the bonds it issues domestically to check inflation.

Other countries also found sterilization more costly after 2008, relating to expansionary monetary policies adopted by advanced economies hit by the financial crisis, most especially the United States.

There can be political pressure from other nations if they feel a country is giving its exporters too much of an advantage, at the extreme this can escalate to currency war.

Sterilization was used by the US and France in the 1920s and 1930s, initially with some success as they built up huge hoards of gold, but by the early 1930s it had contributed to a collapse in international trade that was harmful for the global economy and especially for the surplus nations.