Offset and Sterilization Under Fixed Exchange Rates With An Optimizing Central Bank

Abstract

The traditional approach to the estimation of the offset and sterilization equations can be criticized for the ad-hoc specification of the reaction function of the monetary authorities and the endogeneity of the domestic credit and foreign reserve variables in the estimated equations.The paper proposes an alternative analytical model where the sterilization and offset equations are derived from an explicit maximization problem solved by the monetary authority.In such a model, the optimal intervention and sterilization policies of the monetary authority are shown to be depen- dent on the different disturbances hitting the economy and the preferences of the monetary authority.In particular, under a wide range of domestic and foreign disturbances the optimal response of the central bank will lead to negatively correlated comovements of domestic credit and foreign reserves if the cer1tral bank cares more about the interest rate smoothing objective relative to the foreign exchange reserve stabilization goal.Conversely, positive correlations between domestic credit and foreign reserves will be observed if the foreign reserve objective is dominant.

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