Sterilization in the Context of the Monetary Approach to Balance of Payments

Monetary policy sterilization is the process of counteracting capital inflows and outflows on the domestic money supply by a central bank. This concept is critical in the context of the monetary approach to the balance of payments (MABP), which views balance of payments imbalances as fundamentally tied to discrepancies in the money supply and demand within an economy.

The MABP is based on the notion that the balance of payments is the representation of the financial environment of a country. More precisely, a deficit of balance of payments arises when money demand is less than the supply, thus a credit operation takes place while a surplus is the situation in which a credit operation is being made. These imbalances are corrected by the changes in the domestic money supply, which in turn affect domestic prices, interest rates, and consequently, the exchange rate. For this reason, the important dimension of the central bank is the management of these flows.

Upon a country's experiencing a balance of payments surplus, direct investments from abroad might cause the domestic money supply to expand, and as a result, prices might go up. A central bank may decide to make no money available in the economy and thus counteract these forces. Usually, this technique is implemented by the central bank by selling government bonds as one way of reducing extra liquidity. On the flip side, in the case of a balance of payments deficit, where there is an outflow of capital reducing the money supply, the central bank might buy government bonds or engage in other monetary operations, like lowering the federal funds rate, thus injecting liquidity back into the economy. Through these, the central bank aims to stabilize the money supply, avoid systemic risk and thus protect the economy from unpredictable outcomes.

The efficiency of sterilization in part relies on a central bank's capability to exercise open market transactions and the flexibility of capital. In a highly open economy with free capital movements, it would be more difficult to maintain control over money supply since capital flows might be very large and volatile. Also, lasting sterilization ends up in heightened interest rates, drawing in more capital inflows and, therefore, policy intervention, which would be repeated, thus setting up a possible successive course of action. This is frequently called the "sterilization dilemma."

Additionally, persistent sterilization can be fiscal concerns as the costs of these operations may get higher in time. For instance, the selling of government bonds for absorbing liquidity could result in government's life debts and the subsequent interest costs. Therefore, even though sterilization is the best option in the short term for the money flow, it is not a one-size-fits-all solution for an economic balance that is fundamentally not good.