Central Bank Reserves and Currency Volatility

Abstract

In light of the evidence on significant accumulations in foreign reserves in the post-crisis period, we investigate the neutrality of Central Bank interventions and the collateral implications on their balance sheets. We present a hybrid macro-microstructure model in which foreign exchange rate intervention flow is a non-linear mapping of the market order flow, that is, the net of buyer-initiated over seller-initiated dealers' trades. Simulations in the cases of Brazil and the UK show that small daily drifts in the order flow can lead to major impacts on the stock of foreign reserves. The likelihood of this (adverse) effect on foreign reserves increases with the Central Bank's inability to adopt a neutral policy with respect to exchange rate drifts.

Keywords: exchange rate, central bank interventions, reserve accumulation

JEL Classification: F31, F33, F37