July 25, 2008 (LBO) – Pakistan should stop printing money to bridge budget gaps to avoid further currency depreciation and loss of foreign reserves, the International Monetary Fund has said. The new money increases demand for goods, and usually cause imports to go up, which in turn increases demand for foreign exchange.
If the monetary authority does not allow the currency to float (many South Asian central banks have pegs to the US dollar also known as dirty floats where they claim to ‘intervene to smoothen out excessive volatility of the exchange rate’) it has to run down foreign reserves to defend the peg.
Ideally this should shrink the domestic monetary base (reserve money) and drive interest rates up, causing an automatic ‘tightening’ of monetary policy.
But if the central bank is unwilling to let rates move up, (which is usually the case when it has a policy rate environment) it will resist the contraction of the monetary base and pump in more money into the system by purchasing more domestic assets (government securities) through open market operations, in a process known as ‘sterilized intervention’.
The new money causes yet more demand for imports and yet more pre