Foreign exchange intervention in an exchange rate pair works by augmenting the market supply and demand for assets denominated in the two currencies involved. When a central bank intervenes in the foreign exchange market, the domestic asset traded is always, in the first instance, domestic base money. In the case of sterilised intervention though, this flow of base money is offset, either by selling bonds to recover the base money sold, or buying bonds to replenish the money supply when base money is purchased. Effectively, sterilised intervention trades domestic bonds against foreign bonds, but the exchange rate is a factor in their price difference (for the purposes of this post it is assumed that sterilised intervention does affect the exchange rate).
The mechanism by which intervention affects the two currencies involved may be understood by analogy to a physical system governed by Newton’s third law of motion “every reaction has an equal and opposite reaction”, such as the boats on an ocean shown in Figure 1.
The boats represent currencies, and the distance between any pair represents their relative value or exchange rate. The position of any boat on the sea represents the wider value of the corresponding currency relative to all other currencies (and indeed anything else that the currency can buy, including goods and services). By pulling or pushing against another vessel, a sailor in one boat can shift its position relative to the other, just as trading between two currencies can affect their exchange rate. Consistent with Newton’s third law, applying a force on one boat from another will also shift their absolute positions on the sea, by an amount for each boat that is inversely proportional to its mass. If a light boat such as a dinghy pulls on a heavy ship, for any given change in their separation, the absolute position of the dinghy moves further than that of the ship. Here, the mass of a boat is analogous to the total volume of transactions in a currency; if a currency is heavily traded, a foreign exchange transaction of given size accounts for a small fraction of the market turnover involving that currency and can therefore be expected to have proportionately little impact on its overall exchange value.
Typically, a currency peg involves fixing a minor - ie comparatively lightly traded - currency to a major one like the US dollar. This means that intervention to maintain the peg works mainly by changing the exchange value of the minor currency and has relatively little effect on the overall value of the major currency. A corollary is that the peg could be operated almost as effectively via foreign exchange transactions against another major currency to which the minor currency is not pegged. To use the boat analogy, a sailor in a dinghy wanting to move towards, say, the SS Dollar (Figure 1a) could move almost as far towards the SS Dollar by pulling against another large ship lying alongside it, such as the SS Euro (Figure 1b). The practical implication is that it is not necessary to deal in, and therefore not necessary to hold, assets denominated in a particular currency in order to peg to that currency, although it would be most efficient (in terms of the volume of transactions required) to deal against the peg currency, especially if it is not far more heavily traded than the pegged currency.
There could be various reasons why a country that pegs its currency to another might not want to deal in or hold that currency in its reserves. One explanation might be that the peg currency is not freely traded on the foreign exchange market (ie it is not fully convertible). This may be the case when the peg currency is that of a key trade partner such as a neighbouring country and is itself a minor currency. It could be preferable to hold assets denominated in
The relevance of this discussion to the present international macroeconomic situation is that, if, in the light of the apparent willingness of the US Federal Reserve to jeopardise the value of the dollar by keeping interest rates low to stimulate economic activity and by taking on large contingent liabilities like those incurred in the rescue of Bear Stearns,