Does central bank intervention stabilize foreign exchange rates?

Federal Reserve Bank of Kansas City - Economic Review, First Quarter 1996 by Bonser-Neal, Catherine

Since the adoption of a flexible exchange rate system in 1973, central banks of most industrialized countries have continued to intervene in foreign exchange markets. One reason is that exchange rate volatility has increased. To reduce volatility, many European countries have agreed to keep exchange rates within a band around a target exchange rate, implementing this policy by intervening in foreign exchange markets when necessary. Even without an explicit exchange rate commitment, countries such as the United States and Japan have intervened in foreign exchange markets to help stabilize exchange rates.

Opinions differ on whether central banks can stabilize exchange rates. Some analysts believe central bank intervention can reduce exchange rate volatility by stopping speculative attacks against a currency. Other analysts, though, believe central bank intervention may increase volatility if the intervention contributes to market uncertainty or encourages speculative attacks against the currency.

This article presents empirical evidence on this controversy. The first section discusses why exchange rates are volatile and why policymakers may want to reduce volatility. The second section examines how central bank intervention may affect volatility. The third section presents empirical evidence suggesting that central bank intervention does not generally reduce exchange rate volatility. Rather, central bank intervention typically appears to have had little effect on volatility.

EXCHANGE RATE VOLATILITY

This section discusses the causes and consequences of exchange rate volatility. Also discussed are various ways to measure exchange rate volatility.

Causes of volatility

Exchange rate volatility is often attributed to three factors: volatility in market fundamentals, changes in expectations due to new information, and speculative "bandwagons" (Engel and Hakkio). Volatility in market fundamentals, such as the money supply, income, and interest rates, affects exchange rate volatility because the level of the exchange rate is a function of these fundamentals. For example, large changes in the money supply can lead to changes in the level of the exchange rate. Changes in the level of the exchange rate in turn imply exchange rate volatility.

Changes in expectations about future market fundamentals or economic policies also affect exchange rate volatility. When market participants receive new information, they alter their forecasts of future economic conditions and policies. Exchange rates based on these forecasts will also change, thereby leading to exchange rate volatility. For example, news about a change in monetary policy may cause market participants to revise their expectations of future money supply growth and interest rates, which could alter the level and hence the volatility of the exchange rate.

In addition to being affected by expectations of future fundamentals and policies, volatility is also affected by the degree of confidence with which these expectations are held. For instance, if traders are uncertain about their forecasts of future economic conditions, they are more likely to revise their currency positions once new information becomes available. These revisions to currency positions in turn imply an increase in the frequency, and hence in the volatility, of exchange rate changes. In brief, exchange rate volatility tends to rise with increases in market uncertainty about future economic conditions and tends to fall when new information helps resolve market uncertainty.

Finally, exchange rate volatility can be caused by speculative bandwagons, or speculative exchange rate movements unrelated to current or expected market fundamentals. For example, if enough speculators buy dollars because they believe the dollar will appreciate, the dollar could appreciate regardless of fundamentals. If it then becomes apparent that market fundamentals will not sustain such an appreciation, active selling by the same speculators could cause the dollar to depreciate. Swings in the value of the dollar arising from such speculative forces can contribute to exchange rate volatility.

Consequences of volatility

Regardless of its origin, there are several reasons why authorities may want to reduce exchange rate volatility (Becketti and Sellon). One reason is that volatility may impede international investment flows. By adding risk to the rate of return on a foreign asset, exchange rate volatility may reduce investment in foreign financial assets. In addition, companies may be reluctant to build a new plant or purchase a foreign company if exchange rate uncertainty reduces the expected profits from such projects. As a result, exchange rate volatility could disrupt the efficient allocation of resources in the world economy by creating a disincentive for investment capital to move abroad.

Another reason why authorities may want to reduce volatility is that it may adversely affect international trade. Volatile exchange rates create uncertainty about the revenues to be earned on international transactions. Such volatility could force companies to add a risk premium to the costs of goods they sell abroad. If these costs are passed on to consumers in the form of higher prices, the demand for traded goods could decrease. In addition, firms themselves may be more reluctant to engage in international trade if exchange rate volatility adds an extra risk to their profits.