On the Effectiveness of Foreign Exchange Intervention: The Role of Domestic Fundamentals
39 Pages Posted: 31 Jan 2024 Last revised: 23 Jan 2024
Abstract
Under the right conditions, foreign exchange intervention (FXI) plays an important role in stabilizing currencies in emerging markets. Using a panel smooth transition regression model for 20 emerging economies, the paper finds that central banks lean against the wind of currency depreciation (appreciation) and deviation from long-run targets. Though FXI is effective in stabilizing the exchange rate, however, this effectiveness depends on prevailing macroeconomic conditions - exchange rate volatility and inflation differential. In countries where volatility is low, FXI proves to be effective since market conditions are relatively stable. However, intervention does not impact the exchange rate in countries with high volatility due to external shocks that could overshadow central bank interventions. The opposite is the case when inflationary conditions are examined. FXI is effective in countries with high inflation, which identifies FXI as a tool to counteract inflation-induced currency pressures. These findings convey policy implications for central banks. Firstly, they should choose the optimal size of intervention based on the prevailing macro conditions. Secondly, intervention would be effective if the monetary authority is credible and transparent, enhancing FXI transmission channels.
Keywords: Foreign Exchange Intervention, Exchange Rates, Volatility, Reserves, Panel Smooth Transition, Inflation
JEL Classification: F31, E52, E58, C23
Suggested Citation: Suggested Citation