Central Bank Reserves and Currency Volatility

Abstract

We investigate the effects of sterilized Central Bank interventions designed to smooth exchange rate volatility but 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, precautionary-led accumulation in the case of the 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 a major impact increases with the Central Bank's inability/unwillingness to adopt a neutral policy regarding the drifts.

Keywords: exchange rate, central bank interventions, reserve accumulation

JEL Classification: F31, F33, F37