Sterilized intervention under excess supply of foreign exchange: Is the Trilemma valid?

Abstract

This article explores the challenges of monetary policy in small open economies
facing a sustained excess supply of foreign exchange (FX) in the domestic market. In this
context, the conventional prescription based on the open-economy trilemma suggests that
central banks cannot simultaneously manage both interest rates and exchange rates. However,
governments may wish to continue conducting monetary policy while avoiding domestic
currency appreciation, as this could conflict with their development goals. Can policymakers
avoid the trilemma prescription in this case? The article analyzes the theoretical
foundations of the trilemma and discusses its potential limitations. It begins by examining
the uncovered interest parity (UIP) condition, which underpins the trilemma, emphasizing
that arbitrage forces do not always equilibrate returns due to factors such as market incompleteness,
transaction costs, and exchange rate risk/uncertainty. It then demonstrates that, in
the case of an excess supply of foreign currency, the central bank can intervene in the FX
market and use sterilization to maintain interest rates unchanged, provided it has the capacity
to issue domestic bonds. The central bank’s ability to endogenously adjust the supply of
domestic assets to meet excess demand is a key theoretical element that contradicts the trilemma,
which implicitly assumes that the stocks of both domestic and foreign assets are
fixed. Finally, a model is developed to assess the conditions under which central banks can
successfully manage both interest rates and exchange rates while fulfilling the solvency condition.

JEL Classification: E52; F31; F41.