RESPONSE: There are basically two conventional responsibilities of the central bank: firstly, they must manage interest rates in a manner such that inflation is minimized while economic growth is minimized. Second, they must ensure that the exchange rate does not disrupt the national objectives. As it so happens, there are two tools by which this is done.

Tool One is Open Market Operations; if the USA were a small country, this would probably be the activity getting the most attention. Open market operations consist of buying or selling bonds issued by the Treasury Department . When the Fed performs open market operations, it buys treasury bonds; rather than actually pay for the bonds, the Fed credits the account of the buyer—a bank, of course—increasing its allotted reserves and allowing the bank to create credit at a rate equal to the inverse of the reserve requirement times the net increase in reserves. In plain English, this means the buyer-bank is able to increase M2 by about ten times the amount bought in Open Market operations.¹ By doing so, the central bank can create liquidity in a crisis such as the Oct 1987 stock market "correction." By the reverse action, the central bank can reduce the amount of hot money in circulation if there is inflationary risk.

The other tool available to the monetary authorities is the administration of the interest rate. My previous entry has introduced the methods whereby even small shifts in the interest rate can have a dramatic effect on the forward rate of the home currency in world markets, followed strong upward pressure on the spot rate. In the USA, the most direct form of centralized control over the spot rate is through the discount rate, the rate at which the Fed lends money to member banks. In a system of extremely efficient markets and a highly talented team of authorities, the entire pyramid of interest rates moves in neat formation relative to the discount rate. In situations where there is creeping inflation or an open clash between the Treasury and the Fed, then this synchronicity breaks down.

A third tool is the reserve requirement, but this has huge, difficult-to- manage-effects and is very seldom done.

The general answer is that monetary authorities "sterilize" any intervention when they the respond to one mandate with one tool (like stimulating the economy by trying to reduce interest rates, while trying to prevent the growth in money supply from causing the home currency from declining. It seems to be used most frequently when the central bank—trying to defend an exchange rate peg, perhaps—buys its own currency, sells that of the other country, and reduces the supply of hot money. While the monetary authorities may not have intended to wreck their domestic economy whilst defending their own fixed exchange rate, that is a real risk when banks intervene on the market to buy back their own currency. In order to prevent a currency peg defense from triggering a recession, the CB prefers to reduce interest rates. This is the most common form of sterilization.