Central Bank Reserves and Currency Volatility

Abstract

We investigate the effects of Central Bank interventions which are designed to smooth exchange rate volatility but are not aimed at a particular trend level. We present a model in which the intervention flow is a non-linear mapping of the market order flow. Simulations show that small daily drifts, Brexit-led in the case of Bank of England and commodity-driven in the Central Bank of Brazil, lead to major impacts on both the stock of foreign reserves and the distribution of currency returns. The likelihood of this increases with the Central Bank's inability to adopt a neutral policy regarding the drifts.

Keywords: exchange rate, central bank interventions, reserve accumulation

JEL Classification: F31, F33, F37