Official Intervention in the Foreign Exchange Market: Is ... · Taylor (1982), Dominguez and Frankel (1993a), Hali Edison (1993), Keith Pilbeam (1991), and Geert Almekinders (1995)

Journal of Economic LiteratureVol. XXXIX (September 2001), pp. 839–868

Sarno and Taylor: Official Intervention in the Foreign Exchange Market Journal of Economic Literature, Vol. XXXIX (September 2001)

Official Intervention in the ForeignExchange Market: Is It Effectiveand, If So, How Does It Work?

LUCIO SARNO and MARK P. TAYLOR1

1. Introduction

OFFICIAL EXCHANGE rate interven-tion in the foreign exchange market

occurs when the authorities buy or sellforeign exchange, normally against theirown currency and in order to affect theexchange rate. Whether or not officialexchange rate intervention is effective ininfluencing exchange rates, and themeans by which it does so, are issues ofcrucial policy importance, and they havebeen the subject of a vast academic andpolicy-related literature.

Given the policy importance of offi-cial intervention, it is perhaps not sur-prising that this literature has been thevenue for a substantial and ongoingeconomic controversy. Insofar as a con-

sensus is discernible among economistsand policy makers concerning the effec-tiveness and desirability of exchangerate intervention, it appears to haveshifted several times over the pastquarter of a century. At the time of thecollapse of the Bretton Woods adjust-able peg exchange rate system in theearly 1970s, when the impotence ofthe authorities to hold the parities inthe face of massive speculative attackshad apparently been demonstrated onlytoo well,2 the profession appearedstrongly to favor a pure float, involvingzero intervention. The 1970s experi-ence with floating exchange ratesamong the major industrialized coun-tries, and the ensuing volatility of bothnominal and real exchange rates, how-ever, led to a shift in this consensus sothat, by the late 1970s, both economistsand policy makers—particularly ofcountries which had suffered a substan-tial loss in competitiveness—frequentlycriticized the U.S. authorities for notintervening in support of the dollar.

Nevertheless, partly as a result of therealization of the speed and ease with

839

1 Sarno: University of Warwick, CEPR, and Fed-eral Reserve Bank of St. Louis. Taylor: Universityof Warwick, CEPR, and World Bank. We aregrateful to the editor, John McMillan, and threeanonymous referees for thoughtful and construc-tive comments on a previous version. We are alsograteful to Mike Artis, Michael Bordo, RichardClarida, Bob Flood, Charles Goodhart, PeterKenen, Richard Lyons, Michael Melvin, MarcusMiller, Chris Neely, Bill Poole, Dan Thornton,Ignazio Visco, Paolo Vitale, Axel Weber, JohnWilliamson, and Sushil Wadhwani for helpfulcomments on previous drafts. The paper waspartly written while Sarno was a Visiting Scholar atthe Federal Reserve Bank of St. Louis and Taylorwas a Consultant at the World Bank. The viewsexpressed in the paper and any errors that mayremain are the authors’ alone.

2 John Williamson (1977, p. 50) notes: “By thetime that the adjustable peg was abandoned, capi-tal mobility had developed to the point where theBundesbank could take in well over $1 billion inan hour when the market had come to expect thatanother parity change was impending.”

which capital could move betweendeveloped countries, the prevailingconsensus among economists, policymakers and foreign exchange marketpractitioners during the early 1980s ap-peared to be that intervention—and inparticular sterilized intervention, wherethe effects of intervention on the do-mestic money supply are neutralized—was not effective over anything but thevery short run. Not only was this viewprevalent among academic economists,it also appeared to be the consensus viewof policy makers, symbolized by the conclu-sions of the Jurgensen Report (PhillippeJurgensen 1983) on exchange rate inter-vention which was commissioned by the1982 G73 Economic Summit of Headsof Government at Versailles.4

Following the strong and chronicovervaluation of the U.S. dollar duringthe early to mid 1980s, and a commu-niqué issued by the leaders of the G5industrialized countries at the PlazaHotel in New York in September 1985to the effect that concerted interventionwould be undertaken to bring down thehigh dollar, however, the consensus ap-peared to have shifted once more.5 Fol-

lowing the decline of the U.S. dollarduring the late 1980s, a subsequentmeeting of the leaders of the G7 indus-trialized nations, held at the Louvre inParis in February 1987, led to theagreement that coordinated exchangerate intervention should be undertakento stabilize the U.S. dollar within in-formal “reference ranges,” althoughprecise target zone bands were notestablished.6

Following the Plaza and Louvremeetings, official intervention in themarkets for the major exchange rateshas been regular and at times heavy(Maurice Obstfeld 1990). In addition,exchange rate intervention, togetherwith macro policy coordination, playedan important role in the Exchange RateMechanism (ERM) of the EuropeanMonetary System (EMS) of target zonesbetween European exchange rates.7

3 The Group of 7 or G7 countries are the U.S.,Japan, Germany, France, the U.K., Italy, and Can-ada. The first five countries listed above are theGroup of 5 or G5 countries.

4 The Jurgensen Report did not provide very ex-plicit conclusions. The official press release of thefinance ministries and central bank governors ofthe G7 stated, however, that the main results ofthe Jurgensen Report may be summarized as fol-lows: sterilized intervention affects long-run ex-change rates much less than nonsterilized inter-vention; sterilized intervention can influenceexchange rates only in the short run; coordinatedintervention can be much more powerful relativeto official intervention by a single country’sauthorities.

5 Some authors argue that this embodiment of anew intervention regime started at the beginningof 1985, since the dollar had its peak in February1985 and was already depreciating at the time ofthe Plaza Agreement. In fact, large sales of dollarswere operated by some European Central Banks(especially the Bundesbank) in February and

March of that year (see Kathryn Dominguez andJeffrey Frankel 1993a).

6 The agreement is clearly embodied in the fol-lowing quotation from the official press release ofthe Louvre Accord: “The Ministers and Governorsagreed that the substantial exchange rate interven-tion since the Plaza Agreement will increasinglycontribute to reducing external imbalances andhave now brought their currencies within rangesbroadly consistent with underlying economicfundamentals . . . Further substantial exchangerate shifts among their currencies could damagegrowth and adjustment prospects in theircountries.”

7 Following the ERM crisis of 1992–93 and anumber of other currency crises during the 1990s,there have been calls from various quarters formeasures to be put in place to safeguard againstspeculative attacks when they are apparently unre-lated to the underlying economic fundamentals. In1994, for example, the Bretton Woods Commis-sion, headed by former Chairman of the FederalReserve Paul Volcker, recommended that the IMFset up an intervention fund to help countries staveoff attacks on their currencies (see e.g., TheEconomist 1995). In a related literature, econo-mists have debated the desirability and feasibiltyof imposing capital controls or taxes on foreignexchange transactions as a means of “throwingsand in the wheels of finance” (James Tobin 1969;Barry Eichengreen and Charles Wyplosz 1993;Eichengreen, Tobin, and Wyplosz 1995; PeterGarber and Taylor 1995).

840 Journal of Economic Literature, Vol. XXXIX (September 2001)

Following the introduction of the euroas the single European currency inJanuary 1999 and its immediate andpersistent depreciation against the U.S.dollar, calls for concerted interventionamong the industrialized countries tosupport the euro have at times beenquite strong. Indeed, exactly such con-certed intervention by the G7 countriesdid occur in September 2000.8

This paper summarizes the presentauthors’ reading of recent research onofficial exchange rate intervention—what we have learned, what puzzlesremain, and where further researchprogress is most likely to be made.While the survey will be of use to spe-cialists in international finance andmacroeconomics, given the policy im-portance of the issue in hand we alsobelieve that our assessment of the cen-tral question motivating our analysiswill be of interest to a wider audienceof economists and policy makers: is offi-cial exchange rate intervention effectiveand, if so, how does it work?9

2. The Mechanics of Intervention:Nonsterilized versus Sterilized

Operations

Official intervention is said to besterilized when the authorities—simul-taneously or with a very short lag—takeaction to offset or “sterilize” the effectsof a change in official foreign assetholdings on the domestic monetarybase. On the other hand, nonsterilizedintervention occurs when the authori-ties buy or sell foreign exchange, nor-mally against their own currency with-out such offsetting actions. Clearly,nonsterilized intervention will affect di-rectly the domestic money supply andtherefore its effect on the exchange rateis contentious only insofar as the effectsof changes in the money supply on theexchange rate are contentious—a debatethat perhaps belongs more to the areaof exchange rate determination (e.g. seeTaylor 1995).

In general, a strong consensus existsin the profession that nonsterilized in-tervention can influence the exchangerate similarly to monetary policy byinducing changes in the stock of themonetary base which, in turn, in-duces changes in broader monetaryaggregates, interest rates, market

8 Calls for concerted intervention appeared toreach a peak at the IMF and World Bank annualmeetings in Prague in September 2000, when, at apress conference on September 19, the IMF’sEconomic Counsellor and Director of the Re-search Department, Michael Mussa, asked thememorable question, “If not now, when?” The G7intervention actually occurred a few days later, onSeptember 22.

9 While there are some other excellent existingsurveys on issues related to official intervention,they are all in book form and now require updat-ing—see, for example, Peter Kenen (1988), DeanTaylor (1982), Dominguez and Frankel (1993a),Hali Edison (1993), Keith Pilbeam (1991), andGeert Almekinders (1995). Because of space con-straints, we largely confine ourselves to coveringthe literature which has been published during thelast twenty-five years or so since the breakdown ofthe Bretton Woods system, but devote particularattention to studies published in last decade or so.Important earlier contributions would includeJohn Maynard Keynes (1923) and Kenen (1960,1965).

Because of space limitations, we also do not dis-cuss the literature relating to the role and effec-tiveness of intervention in target zone exchange

arrangements. On this see, inter alios, Williamson(1985), Paul Krugman (1991), and Williamson andMarcus Miller (1987).

See also the papers in Matthew Canzoneri, Wil-fred Ethier and Vittorio Grilli (1996), which covera number of issues related to “The New Translan-tic Economy,” ranging from transatlantic policycoordination with sticky labor markets to coordi-nated exchange rate intervention following thePlaza and Louvre agreements in comparison withthe experience of the European Monetary Systemprior to the 1992 crisis, inter alia. For a treatmentof exchange rate intervention and related issues inthe Pacific Basin, see also Reuven Glick (1998);for a broader treatment of the issues related tocentral banks’ behavior and economic perfor-mance, see Sylvester Eijffinger (1997). See Sarnoand Taylor (2001) for textbook treatment of all ofthese issues.

Sarno and Taylor: Official Intervention in the Foreign Exchange Market 841

expectations and ultimately the ex-change rate. The effectiveness of steril-ized intervention is very controversial,however, and, accordingly, the core ofthe debate on the effectiveness of offi-cial intervention in the foreign exchangemarket largely relates to sterilizedintervention.10

Consider table 1, which gives a styl-ized representation of the balance sheetof a country’s monetary authorities(that is, the central bank and exchange-stabilization authorities combined).

The monetary base comprises cur-rency and deposit liabilities to banks.Net worth of the financial authoritiesincludes accrued spending surpluses,accumulated net interest receipts andcapital gains on their holdings of netdomestic and foreign assets. From table1, it follows that:

M ≡ NFA + (NDA − NW) ≡ NFA + DC (1)

where DC, defined as net domestic assetsless net worth (DC ≡ NDA − NW), repre-sents the stock of domestic credit madeavailable by the monetary authorities.

Foreign exchange market interventionby the monetary authorities involves apurchase or sale of foreign assets. Whenofficial intervention is nonsterilized, the

purchase (sale) of foreign currency bythe authorities leads to an increase(decrease) in NFA and an equivalentincrease (decrease) in M. Therefore,nonsterilized intervention has the sameimpact on monetary liabilities as anopen market operation, and the onlydifference between the two is that by anonsterilized intervention operation themonetary authorities alter M through achange in foreign asset holdings ratherthan through a change in domestic assetholdings.

On the other hand, if intervention isfully sterilized then domestic credit isaltered so that

∆DC = −∆NFA (2)which implies

∆M = ∆NFA + ∆DC = 0 (3)

where ∆ denotes the change in the rele-vant stock. Normally, intervention wouldbe sterilized by sales or purchases ofdomestic-currency bills or bonds by themonetary authorities so that the effectson the monetary base of changes in theholdings of net foreign assets are in factoffset one-for-one by the effects ofchanges in net domestic asset holdings:

∆NDA = −∆NFA. (4)We now turn to analyzing the two

channels of influence of official ex-change rate intervention and explain

10 For an early elegant description of the me-chanics of exchange rate intervention, see DonaldAdams and Dale Henderson (1983).

TABLE 1MONETARY AUTHORITIES’ STYLIZED BALANCE SHEET

Assets Liabilities

Net foreign assets (NFA)GoldForeign

Monetary base (M)Total currency in circulationReserve liabilities to commercial banks

Net domestic assets (NDA)Government securitiesLoans on commercial banksOther

Net worth (NW)Spending surplusesNet interests and capital gains from assets


how, in theory, these channels work. Insection 4 we will evaluate the empiricalevidence to date as to whether theywork in practice.

3. How Does Intervention Workin Theory?

A standard and useful taxonomy foranalyzing how sterilized interventionmay affect the exchange rate is by refer-ence to two channels of influence ofsuch intervention operations: the port-folio balance channel and the expecta-tions or signalling channel (see MichaelMussa 1981).

3.1 The Portfolio Balance Channel:Theory

The effects of official interventionthrough the portfolio balance channelcan be analyzed within the frameworkof a portfolio balance model (PBM) ofexchange rate determination in whichinvestors balance their portfolio among theassets of various countries on the basisof their relative expected returns.11

In the PBM, the assumptions whichunderlie both the flexible price and thesticky price monetary model of the ex-change rate, i.e. that domestic and for-eign assets are perfect substitutes andthat the wealth effects of a currentaccount imbalance are negligible, arerelaxed. The PBM may be seen as adynamic model of exchange rate deter-mination based on the interaction of in-ternational asset markets, current ac-count imbalance (reflecting net foreignasset accumulation or decumulation)and the exchange rate (see e.g. Branson1983, 1984; Michael Dooley and PeterIsard 1983; Taylor 1995).

After the authorities have intervened

in the foreign exchange market andthen sterilized the intervention therecan, by definition, be little or no effecton domestic interest rates since thelevel of the money supply has remainedconstant. What has altered, however, isthe composition of agents’ portfolios,since the authorities will have bought orsold domestic assets in their steriliza-tion operations. The spot exchange ratemust therefore shift in order to affectthe domestic value of foreign bonds andthe expected return for holding them.This occurs as agents try to rebalancetheir portfolios by buying or selling for-eign assets. For example, an increase inthe supply of euro-denominated assetsin the hands of the public relative tothe supply of dollar-denominated assetsnecessitates a fall in the relative priceof euro-denominated assets. This ishow, in theory, intervention affects theexchange rate through the portfoliobalance channel.

If domestic and foreign assets are re-garded by agents as perfect substitutes,however, sterilized intervention mayhave no significant effect on the ex-change rate through the portfolio bal-ance channel. This follows becauseagents will be indifferent as to the rela-tive amounts of domestic and foreignassets they are holding—they will careonly about the total amount and henceno change in market-clearing prices orquantities is required. Suppose, for ex-ample, that the authorities purchaseforeign exchange and carry out an openmarket sale of domestic bonds in orderto sterilize the effect of a rise in officialreserves on the money supply. If do-mestic and foreign bonds are perfectsubstitutes in private agents’ portfoliosand agents’ portfolios were initially instock equilibrium, then investors willsell foreign bonds one for one with theincrease in domestic bonds. Thus, theprivate sector will sell the same amount

11 For space constraints, we do not outline ana-lytically the PBM here. For a formal discussion ofthe PBM, see, for example, Kenen (1982), WilliamBranson and Henderson (1985), and Taylor(1995).


of foreign currency that the authoritiesbought, and there will be a zero neteffect on the level of the exchange rate.

In a world of high-speed capital flowsone might suspect that financial assetsdenominated in the currencies of themajor industrialized countries may in-deed be highly substitutable in domes-tic portfolios, and—as we shall seebelow—this issue has been addressedby researchers.

At a theoretical level, it should alsobe noted that in a Ricardian world,where private agents offset expectedfuture tax payments (which will berequired to service extra governmentdebt) against currency holdings of do-mestic bonds (Robert Barro 1974), im-perfect substitutability would no longerbe a sufficient condition for sterilizedintervention to influence the currentexchange rate. If Ricardian equivalencedoes not hold, however, and domesticand foreign bonds are less than per-fectly substitutable, official interventionwill in theory have a net effect on thelevel of the exchange rate through theportfolio balance channel.12

3.2 The Signalling Channel: Theory

Even if perfect substitutability of do-mestic and foreign assets holds, steril-ized intervention can still in theory beeffective through the signalling or ex-pectations channel (Mussa 1981). Thebasic idea here is that agents may viewexchange rate intervention as a signalabout the future stance of policy. Be-cause the exchange rate is a forward-looking variable, a shift in expectationsconcerning future movements in vari-ables affecting the exchange rate—suchas relative money supplies—will affectthe level of the exchange rate now.

In essence, the signalling channel as-

sumes that intervention affects ex-change rates by providing the marketwith new relevant information, underthe implicit assumption that theauthorities have superior information toother market participants and that theyare willing to reveal this informationthrough their actions in the foreignexchange market. More precisely, theeffect of sterilized intervention throughthe signalling channel occurs becauseprivate agents change their exchange rateexpectations either because they changetheir view with regard to the likely fu-ture actions of the monetary authoritiesor because they change their view withregard to the impact of certain actionsof the monetary authorities.

Notice that, since unsuccessful inter-vention is costly, if official interventionis expected to be effective through thesignalling channel, there is an incentivefor the authorities to manifest clearlytheir policy intentions. In this sense, itis perhaps something of a mystery as towhy monetary authorities often main-tain secrecy of intervention operations.As Kenen (1988, p. 52) puts it: “Therules for exchange rate managementshould be as transparent as possible.That is to maintain credibility, not bystudied ambiguity, which breeds dis-agreement and distrust.” At any time,however, a government will be pursuingmany macroeconomic policy goals andthe trade-offs amongst these will behighly complex, hence complicating sig-nificantly the judgement of other mar-ket agents about the time consistencyof a certain announced exchange ratepolicy.

Some influential theoretical literaturehas analyzed these issues in the contextof a framework in which market agentshave incomplete information about theauthorities’ utility trade-off betweenthe exchange rate target and a domesticpolicy target. Within this framework,

12 See also Frankel (1979), Obstfeld (1982),David Backus and Patrick Kehoe (1989).


for a policy to be time consistent, theauthorities must announce a range forthe future exchange rate since the an-nouncement of any precise target maynot be credible. More generally, themonetary authorities of many majorindustrialized countries tend to adoptexchange rate policies which are con-sistent with the fulfillment of prean-nounced targets of the growth rate ofmonetary aggregates (see Jeremy Stein1989).

The trade-off between the attainmentof a target level of money stock (mt

T)and a target level of the exchange rate(st

T) may be formalized in a simplefashion using a quadratic loss functionfor the monetary authorities of theform:

£t = (mt − mtT)2 + ω(st − st

T)2, (5)

where £t, mt and st denote the loss tothe monetary authorities, the domesticmonetary base and the nominal exchangerate (domestic price of foreign currency)at time t respectively, while ω ≥ 0 is therelative weight attached to the monetaryand exchange rate targets by the mone-tary authorities. If the authorities onlycare about the attainment of the prean-nounced monetary target—say in orderto build their reputation and hencebenefit by relatively lower inflation ex-pectations and wages claims from tradeunions—then ω = 0 in equation (5). Ifω = 0 and no official intervention policyis undertaken by the monetary authori-ties, however, the exchange rate has tobear entirely the burden of adjustment:any expected appreciation of the domes-tic currency will induce speculators tobuy the currency, hence generating theactual appreciation of the currency itself.Alternatively, the monetary authoritiesmay use sterilized intervention whichcan effectively induce the independenceof exchange rates and monetary targets(∆NDA = −∆NFA), ultimately generating

only a change in the composition of theprivate sector’s portfolio (see Almekin-ders 1995 and the references therein).Note, however, that this independenceis contingent upon adequate foreignexchange reserves being available—anissue brought into stark relief by theliterature on speculative attacks, asdiscussed below.

The theory of the signalling channelof official intervention has attracted re-newed interest in recent years. In par-ticular, some researchers have usedsimple two-country models to examinethe theoretical implication of the signal-ling channel of foreign exchange marketinterventions that sterilized inter-ventions represent signals of futuremonetary policy and hence affect ex-change rate expectations. Within agame-theoretic framework which allowsfor partial credibility and nonrationalexpectations, both noncooperative andcooperative policies of exchange ratemanagement can be studied formally.These models predict that, in order tomaintain credibility in the future, steril-ized interventions must be accommo-dated by corresponding subsequentchanges in the money supply, implyingthat official intervention does notrepresent an instrument independentof monetary policy. This framework alsoindicates that the implied trade-offbetween internal and external policyobjectives makes the coordination ofofficial intervention operations advanta-geous, even in the case of conflictingexchange rate targets (see Silke-FabianReeves 1997, 1998).

3.3 International Coordinationand the Channels of Influence

Coordinated (or concerted) officialintervention in the foreign exchangemarket occurs when two or more cen-tral banks intervene simultaneously inthe market in support of the same


currency, according to an explicit orimplicit international agreement ofcooperation.13

The rationale for international co-ordination of official intervention stemsfrom the observed existence of signifi-cant spillover effects of domestic poli-cies across countries. For example,under a floating exchange rate system,official intervention in one country maybe expected to change the value of thedomestic currency with respect to othercurrencies, thereby affecting tradingpartners’ economies. Standard eco-nomic theory suggests that, in an inter-dependent world economy, a Pareto-optimal outcome may be achieved bytaking into account the spillover effectsof macroeconomic policies and by form-ing policies which exploit the existenceof these cross-country interdependenciesfor the mutual benefit of the participantsof the coordinated intervention (RalphBryant 1995).14

With regard to nonsterilized inter-vention, the benefits from coordinationof nonsterilized operations are identicalto the benefits from monetary policy co-ordination. Nevertheless, the advantageof coordination of nonsterilized officialintervention relative to monetary policycoordination is that the former, unlikethe latter, creates an explicit incentiveto coordinate monetary policies consis-tent with exchange rate targets for thecountries involved (see Dominguez andFrankel 1993a).

The advantages of coordination forsterilized exchange intervention are lessstraightforward. In fact, the effective-ness of sterilized intervention throughthe portfolio balance channel is totallyindependent of monetary policy effec-tiveness and, therefore, countries candesign concerted official interventionwithout relinquishing sovereignty overdomestic monetary policy. If sterilizedintervention works through the signal-ling channel, however, there may begains from coordinating official inter-vention. This is because the coordi-nation of multiple signals is more likelyto convince speculators that the sig-nalled policy is credible relative to anindividual signal, implying that steril-ized official intervention coordinationmay help central banks with relativelylow reputation or credibility (Kenen1988, ch. 6; Dominguez and Frankel1993a; Isard 1995, ch. 12).

A recent formal treatment of these is-sues is provided by Marc Flandreau(1998) in the context of a model whereseveral target zones co-exist and pari-ties are defended by manipulatingmoney supplies in participating coun-tries. As a result, interventions aimedat one given exchange rate also af-fect other exchange rates, implyingthat shocks on each fundamental affectthe whole range of exchange ratesinvolved, intramarginal interventions

13 Some researchers use a more restrictive defi-nition of concerted intervention which does notinclude operations which would have been under-taken by the individual central banks even in theabsence of any coordination (e.g. Kenneth Rogoff1984, 1985). In practice, however, concerted offi-cial intervention in the foreign exchange marketamong the major industrialized nations has largelyconsisted of information sharing and discussionswith small modifications of the individual inter-vention operations.

14 The theoretical literature investigating theimplications of policy coordination among inter-dependent economies typically adopts a game-theoretic approach which is commonly referred toas “policy-optimization” analysis. In a typical gamethe rational agents are national governments,whose preferences are formalized using a lossfunction biased toward domestic welfare. Coop-erative and noncooperative games can then beanalyzed and the outcomes from the two types ofgames can be compared in order to infer the opti-mal strategy for governments. In choosing theirloss-minimizing strategy, each national govern-ment also takes into account the preferences andthe reactions of the other governments (e.g.,Willem Buiter and Jonathan Eaton 1985; RichardCooper 1985; Bryant 1995). See also the papers inClas Wihlborg, Michele Fratianni, and ThomasWillett (1991).


arise endogenously and the stationarydistributions of exchange rates and fun-damentals are influenced by the “rulesof the game” regarding currencies usedin intervention and sterilization proce-dures. The model ultimately predictslarge gains from international coordi-nation for all participating countriessince “intramarginal targets” are gener-ated to which exchange rates tend to re-turn and their location is shown to de-pend on the intervention-sterilizationmix adopted by monetary authorities.

Overall, therefore, the existence ofsignificant gains from international co-ordination of official intervention rela-tive to individual intervention and theenhancement of the effectiveness ofintervention through the signallingchannel as an effect of coordinationappear to be accepted theoreticalresults.

3.4 Optimal Exchange RateManagement: Theory

The theoretical literature on optimalexchange rate management to date isenormous (e.g. see, inter alia, the workof Michael Artis and David Currie1981; Jagdeep Bhandari 1985 and thepapers therein; Stephen Turnovsky1987; Kenen 1988; Glick and MichaelHutchison 1989). The conventionaltheoretical analysis mainly focuses ondesigning an exchange rate policy whichminimizes the variance of outputaround its natural rate.15 Also, the tradi-tional approach taken by this literatureis based on a flow model of the ex-change rate which accounts for threetypes of currency flows: flows gener-ated, respectively, by current account

transactions (CA), net flow demand fordomestic currency through the capitalaccount of the balance of payments(∆K) and currency flows generating di-rectly from central bank intervention inthe market (INT) (e.g. see StanleyBlack 1985). The market-clearing con-dition involving those three currencyflows may be written at time t as :

INTt = CAt + ∆Kt (6)

where the left-hand side and the right-hand side of the equation describe thenet supply of and the net demand fordomestic currency respectively. The cur-rent account is assumed to be a functionof measures of competitiveness such asthe real (i.e. relative price level ad-justed) exchange rate. A function for thenet flow demand for domestic currencythrough the capital account of the bal-ance of payments may be derived, forexample, using the framework of specu-lative dynamics models developed byStein (1987) and J. Bradford De Long,Andrei Shleifer, Lawrence Summers,and Robert Waldmann (1990). Accordingto these models, the net internationaldemand for domestic currency will be afunction of a set of factors includingdeviations from uncovered interestparity, the degree of risk aversionof investors and the conditional varianceof the next period spot rate (seeAlmekinders 1995).

The theoretical literature in this con-text essentially models official interven-tion by assuming a particular centralbank loss function from which, given aparticular process governing exchangerate movements, estimatable centralbank reaction functions can be derived.Several authors assume, for example,that the central bank has a single-period, quadratic, symmetric loss func-tion of the deviation of the currentexchange rate from its target level, andthat there are costs of intervening in

15 This implicitly assumes, however, that themain concern of the monetary authorities is tochoose the optimal degree of nonsterilized inter-vention in response to idiosyncratic shocks andtherefore, in some sense, this approach neglectsthe fact that the monetary authorities widely usesterilized intervention.


the foreign exchange market (e.g., seeAlmekinders 1995).16

While this class of models providesuseful insights on the strategic behaviorof the monetary authorities and allowsresearchers to derive reaction functionswhich can be easily estimated, they dosuffer, however, from some drawbacks.In particular, these models treat thecentral bank on the same terms as othermarket participants, who, therefore, donot have any informational gain frommonitoring the actions of the central bank.It may be more appropriate to withdrawthis assumption in future studies. Cen-tral banks should have a larger informa-tion set at least because they know moreabout their own future actions relativeto other market participants.17,18

An important move in this directionis due to Utpal Bhattacharya and PaulWeller (1997), who build an asymmetricinformation model of sterilized inter-vention where the equilibrium is char-acterized by a situation in which thecentral bank has inside informationabout its exchange rate target whereasrisk-averse speculators have inside in-formation about future spot rates. Inthat framework, circumstances mayarise in which “perverse” responses tointervention may occur and ultimatelythe model provides a rationale forsecrecy not only with regard to thescale but also to the target of officialintervention (see also Paolo Vitale1999a).

Game-theoretic approaches have alsobeen undertaken by researchers. Typi-cally, these models analyze the inter-action between the central bank andprivate rational speculators in the for-eign exchange market in the event of ashock observed by both parties. Thecentral bank wishes to counterbalancethe effect of the shock and stabilize theexchange rate. Given the fact that thescale of official intervention is not verysignificant relative to the daily turnoverin the market, the central bank has anincentive to use secret intervention inorder to surprise private speculatorsand increase the effectiveness of theintervention operation. Rational agentswill expect, however, a higher volumeof intervention and, therefore, the ulti-mate result of the game between thecentral bank and the private speculatorsis the generation of some sort of “inter-vention bias.” Clearly, the preferencesof the central bank and the shape of its

16 These costs may be, for example, bureaucraticcosts incurred during the decision-making processfor designing the optimal intervention strategy orfinancial losses caused by a purchase (sale) offoreign currency which is not followed by futureappreciation (depreciation) of the domestic cur-rency. While in the absence of intervention coststhe central bank counteracts to every single idio-syncratic shock, in the presence of positive costs ofintervention, the decision to respond to a shockwith sterilized intervention is based on a cost-benefit analysis of foreign exchange intervention(see Almekinders 1995).

17 On the one hand, if official intervention is towork through the signalling channel, then ideallyevery intervention operation of the central bank inthe foreign exchange market should be announcedpublicly since the announcement increases thechance of the operation being successful. On theother hand, however, some theoretical models(e.g. Alex Cukierman and Alan Meltzer 1986;Nathan Balke and Joseph Haslag 1992) show that anecessary condition for official intervention to beeffective is the maintenance of the informationaladvantage. In this sense, public announcements offuture official intervention by central banks mayheavily undermine the effectiveness of theintervention operation.

18 A recent paper which conflicts with this pre-sumption is due to Owen Humpage (1997), whoinvestigates the forecast value of U.S. interven-tions in the foreign exchange market. The ratio-nale is that evidence of superior forecasting skillwould imply that the U.S. monetary authorities actwith better information than the market and thatintervention could alter foreign exchange traders’expectations about exchange rates. The analysis

presented by Humpage (1997) shows, however,that this was not the case for U.S. official interven-tion during the period 1990–97, and official trans-actions by U.S. monetary authorities do not seemto improve the efficiency with which the foreignexchange market obtains and uses information.


loss function, in addition to the degreeof central bank independence, are cru-cial in determining the final outcome ofthe game between the central bank andthe rational speculators in the market inthese models (see Rogoff 1985; Cukier-man 1992; Eijffinger and Eric Schaling1993; Guy Debelle 1993; and GeorgeAlogoskoufis 1994).

3.5 Intervention, Speculative Attacksand Currency Crises

There is a large theoretical literaturein international macroeconomics onspeculative attacks and currency crises.Although this literature does not explic-itly address the effectiveness of inter-vention, we believe that there are somestrands of it which do yield importantinsights into intervention operations,and that some of the models might beusefully adapted to analyze specificintervention issues.

There are three main strands of thisliterature.19 The first strand—often re-ferred to as the first-generation cur-rency crisis approach—starts with theseminal article by Krugman (1979) andthe subsequent article by Flood andGarber (1984). The key characteristic offirst-generation models is that theauthorities are pursuing a fiscal policywhich is inconsistent with the exchangerate peg. As such, intervention isdoomed to ultimate failure primarilybecause exchange rate policy is incom-patible with the underlying stance ofmonetary and fiscal policy, so that ex-haustion of a finite stock of reserves isinevitable. In addition, the effects ofsterilized intervention through the port-folio balance channel are precluded byassuming a simple underlying monetary

model of the exchange rate, which as-sumes perfect substitutability betweendomestic and foreign assets (so onlynonsterilized intervention is consid-ered), and the signalling effects of in-tervention are ruled out because agentsknow that the authorities’ monetary pol-icy is ultimately unsustainable. The cen-tral insight on intervention operationsfrom these models, however, is thatthey must be ultimately unsuccessful ifthey are inconsistent with the generalstance of macroeconomic policy.20

In second-generation models, theemphasis is generally on policy rulenonlinearities, such as a shift in domes-tic monetary policy conditional onwhether or not there is a speculativeattack (Obstfeld 1994, 1996). A key fea-ture of second-generation models is anescape clause in government policy,whereby there is a fixed penalty forabandoning the exchange rate peg andswitching to a floating regime. Theauthorities then intervene to supportthe peg so long as the value of their lossfunction under this regime is less thanthe value of the loss with a switch to afloat, including the fixed penalty for in-voking the escape clause. Because thereis a simultaneity between the value ofthe loss involved in each regime andwhether or not a speculative attack is

19 For more comprehensive discussions and sur-veys of this literature, see Pierre-Richard Agénor,Bhandari and Robert Flood (1992), Garber andLars Svensson (1995), Olivier Jeanne (1996), andFlood and Nancy Marion (1999).

20 The implicit assumption of perfect substitut-ability between domestic and foreign assets hasbeen relaxed in some modified first-generationmodels (e.g. Flood, Garber and Charles Kramer1996; Flood, Robert Hodrick, Isard and Kramer1996; Flood and Marion 2000). These models al-low a role for sterilized intervention by introduc-ing a risk premium—itself a function of domesticand foreign bond holdings—into the uncovered in-terest rate parity condition. Moreover, Flood andMarion’s (2000) analysis shows how introducingnonlinearity into the model and relaxing the per-fect foresight assumption generates multiple solu-tions and opens up the possibility of self-fulfillingspeculative attacks. These features are, in fact, keycharacteristics of so-called second generation-speculative attack models, so that the Flood-Marion model may be seen in some respects asbridging the “generation gap.”


launched, the model admits multipleequilibria. Interestingly, it is possible toshow that by increasing the penalty ofinvoking the escape clause and aban-doning the peg, the probability of anattack being launched is actually in-creased, which—at least prima facie—appears counter-intuitive (see Floodand Marion 1997a, 1999). One way ofmaking this result more intuitive, and atthe same time seeing the link with ex-change rate intervention, is as follows.Although the cost of invoking the es-cape clause and abandoning the peg isusually interpreted as the authorities’loss of credibility or as a deadweightloss to society, a more immediate inter-pretation is to view it as the transfer ofwealth which is made from the authori-ties to private speculators following asuccessful speculative attack. Thus, themore prolonged and intense the de-fense of the peg—i.e. the more theauthorities intervene—the greater willbe the profit that accrues to speculatorsand the greater the incentive they willtherefore have to attack. Under thisinterpretation of second-generationmodels, therefore, intervention has theperverse effect of making the collapseof a currency more probable. This isan interesting theoretical result whichwarrants empirical investigation.

A large and growing literature onthird-generation models of currencyand financial crises has developed re-cently in the wake of the 1997–98 EastAsian financial and currency crisis.These models were developed primarilybecause the East Asian crisis appearednot to be characterized by the fiscaldeficits which typically trigger a crisisin first-generation currency crisis mod-els, nor did there appear to be anystrong temptation for the authorities toabandon a fixed exchange rate system inorder to pursue a more expansionarymonetary policy, as one might expect in

a second-generation model. In fact,these third-generation models are reallymodels of financial sector crisis ratherthan models of speculative attack orcurrency crisis per se. As such, how-ever, third-generation models have fewimplications for the effectiveness orotherwise of intervention policies. Theimplicit assumption is that a massivecapital flight following the collapse ofdomestic asset market bubbles willswamp intervention operations, leadingto a collapse of the currency.21

Clearly, the three strands of litera-ture on speculative attacks and currencycrises offer rather different—albeitrelated—views of the mechanics of acurrency crisis. Intervention only hasa major role in the context of first-and second-generation models. First-generation models tell a simple, starkstory about intervention policies whichare inconsistent with the underlyingstance of monetary and fiscal policy,namely that they are doomed to ulti-mate failure. Some of the second-generation models, however, tell arather more sophisticated story inwhich prolonged intervention may incertain circumstances actually increasethe probability of a successful attack onthe currency. It is perhaps worth con-jecturing that such models may shedsome light on why monetary authoritiesso often deem it necessary or desirableto intervene in secret, contrary to theintuition which follows from thinking interms of a simple signalling channelframework. It may be that the authori-ties in these cases are attempting to

21 For further discussion of third-generationmodels, see e.g. Ronald McKinnon and Huw Pill(1996), Amar Bhattacharya, Stijn Claessens,Suwati Ghosh, Leonardo Hernandez, and PedroAlba (1998), Edison, Pongsak Luangaram, andMiller (1998), Krugman (1998), GiancarloCorsetti, Paolo Pesenti, and Nouriel Roubini(1999), Menzie Chinn, Dooley, and Sona Shrestha(1999), and Sarno and Taylor (1999).


influence the exchange rate throughthe portfolio balance channel withoutthe danger of triggering a self-fulfillingspeculative attack on the currency. Atpresent, however, this remains a conjec-ture of the present authors, but onewhich we feel would repay furtherresearch.

4. Does Official Intervention Workin Practice?

So far, our discussion of the mechan-ics and effectiveness of intervention hasbeen almost exclusively theoretical. Wenow turn our attention to the vexed ques-tions of whether and how interventionworks in practice.

4.1 Data on Official Exchange RateIntervention and Exchange RateExpectations

The early empirical literature on ex-change rate intervention was handi-capped by the lack of data on two cru-cial variables: data on intervention itselfand data on market participants’ ex-change rate expectations. An attemptwas often made to circumvent the firstlacuna by inferring intervention activityfrom movements in the authorities’ in-ternational reserves, while the assump-tion of rational expectations (often withthe auxiliary assumption of uncoveredinterest rate parity) was generally in-voked to cope with the second gap inthe data.

Monthly and quarterly data on mone-tary authorities’ international reservesare given in most central banks’ statisti-cal publications, while quarterly dataare available, for example, from the In-ternational Financial Statistics databaseof the International Monetary Fund.Movements in these data, however, rep-resent a very inaccurate proxy for inter-vention activity since monetary authori-ties’ international reserves may change

for a number of reasons different fromand often not related to official inter-vention. Reserves increase, for example,with interest receipts on official port-folio holdings, and fluctuate widely withvaluation changes on existing reserves.Most tellingly, reserves do not includetransactions that are in fact interventionoperations, such as the so-called hiddenreserves, which may be seen as changesin official deposits of foreign currencywith domestic currency and are regu-larly used by a number of centralbanks—in particular, they are very fre-quently adopted by the Bank of Japan(see Edison 1993; Dominguez andFrankel 1993a).22

The issue of data availability on ac-tual intervention operations is obviouslyclosely linked to the issue of whysecrecy—or omission of a detailedreport—of official intervention is oftenmaintained by monetary authorities,even after the event. While argumentsmay exist in favor of the secrecy of offi-cial intervention, it is unclear whycentral banks have not been interestedfor a long time in releasing data toresearchers ex post.

A change in this practice has beenmade, however, by the U.S. authorities,and U.S. daily data for intervention arenow available, following the authoriza-tion of the U.S. Treasury to the Boardof Governors of the Federal ReserveSystem to release them in the early1990s. Germany and Japan have re-cently followed the example of theUnited States. The other G7 countrieshave not followed this practice yet and,therefore, the process of gathering

22 Ideally, a study on official intervention at-tempting to be infomative on both short- and long-term effectiveness of official intervention shoulduse minute-by-minute data, since this is the timescale on which intervention of the monetaryauthorities in the foreign exchange market oc-curs. Nevertheless, daily data may represent asufficiently good approximation.


intervention data still requires the re-construction of the operations of themonetary authorities on the basis ofreports of the financial press which,however, is not expected to be compre-hensive of every secret operation, espe-cially small ones which may not beidentified even by traders in the foreignexchange market.23

In addition to the recent availabilityof data on official exchange rate inter-vention, survey data on exchange rateexpectations also became available forutilization during the late 1980s. Thesedata are very useful for modelling ex-pectations mechanisms and testing thesignalling or expectations channel.

Hence at the beginning of the 1990sthe empirical literature on interventionwas able to address the question ofwhether official intervention is effectivemore seriously than the correspondingliterature of the 1980s. The handicapsthat researchers in the 1980s workedunder were essentially removed. In par-ticular, as discussed below, a series ofstudies by Dominguez and Frankel inthe early 1990s significantly raised thestandard of the analysis by using bothintervention data and survey data onexpectations.

4.2 The Portfolio Balance Channel:Evidence

In order to analyze the effectivenessof sterilized official interventionthrough the portfolio balance channel,various studies have focused on the tra-ditional formulation of the PBM underthe assumption that the Ricardianequivalence theorem does not hold. Inthat framework, investors allocate theirwealth among different assets in pro-

portions that are assumed to be increas-ing functions of the expected return oneach asset. Also, under the assumptionthat investors are risk averse and that ratesof return are uncertain, investors maxi-mize expected profits by diversifyingtheir portfolios.

The PBM has not attracted a largeempirical literature relative to othermodels of exchange rate determinationand in particular relative to monetarymodels, mainly because several prob-lems are encountered in mapping thetheoretical framework of the PBM intoreal-world financial data. In particular,the choice of non-monetary assets to beconsidered in the empirical model isdifficult and data are not always avail-able on a bilateral basis.24 In general,however, two types of tests have beenconducted by the relevant empirical lit-erature. The first type is based on esti-mating a reduced form solution of thePBM in order to measure its explana-tory power—this approach is oftencalled the direct demand approach. Thesecond type of test of the PBM focuseson solving the PBM for the risk pre-mium and testing for perfect substitut-ability of bonds denominated in differ-ent currencies—this is the inverteddemand approach.

In testing the portfolio balance modelusing the inverted asset demand ap-proach, researchers typically estimatean equation where the risk premium(say ρ) is a function of domestic andforeign bond holdings (B and B∗) (and,in more complex formulations, of incomeand wealth):

ρt = θ1Bt + θ2Bt∗ (7)

where θ1 and θ2 are parameters andwhere, for simplicity, we have assumed alinear static specification. Typically, the23 See Dominguez and Frankel (1993a) for a

more extensive discussion of these issues, andDiana Weymark (1997a,b) for a discussion ofmethods of constructing indices of interventionactivity on the basis of observed data.

24 See Taylor (1995) for a discussion of theeconometric issues involved in estimating thePBM.


risk premium is measured by deviationsfrom uncovered interest parity, either as-suming rational expectations or employ-ing survey data. Under the null hypothe-sis that assets are perfectly substitutableat home and abroad, the coefficients onthe bond holdings variable should all bezero. On the other hand, if the portfoliobalance channel hypothesis holds, thenthe coefficients on bond holdings shouldbe statistically significant (see e.g. Taylor1995).

In general, in the late 1970s and inthe 1980s, the empirical literature ontesting the PBM suggested that steril-ized intervention is effective at most inthe very short term, while the jointhypothesis of rational expectations andperfect substitutability of domestic andforeign assets was regularly rejected.Also, much of this literature suggeststhat the exchange rate effects of inter-vention through the portfolio balancechannel are very small in size—seeEdison (1993) for a review of the em-pirical studies on testing the portfoliobalance channel in the 1980s.

Some post-1980s support in favor ofsignificant portfolio balance effects isprovided by Atish Ghosh (1992). Theapproach taken involves using a forward-looking monetary model of the ex-change rate in order to capture signal-ling effects. Since the monetary modelimplies that the exchange rate is a func-tion of expected future monetary funda-mentals, the monetary policy signallingeffects must be captured. This thenallows the researcher to test for the ef-fects of sterilized intervention throughchannels other than the signalling chan-nel. Using monthly data for the U.S.dollar-German mark rate over the pe-riod 1980–88, Ghosh provides evidencefor a weak, but statistically significantportfolio influence on the exchangerate. The model also performs well inforecasting, displaying a very high cor-

relation between the actual and fittedvalues of the exchange rate and out-performing an alternative random walkmodel in out-of-sample forecasting. In asense, this approach is mildly “schizo-phrenic” (Ghosh 1992, p. 217), in that asignificant portfolio balance effect im-plies rejection of the monetary model,but various indicators of the monetarymodel’s performance, such as in-samplefit and predictive performance, indicatethat “the model provides a reasonablefilter for removing the influence ofagents’ expectations of future policies”(ibid).25

The conventional wisdom of officialintervention ineffectiveness through theportfolio balance channel has beenstrongly challenged by Dominguez andFrankel (1993b). Using survey data onU.S. dollar-German mark and U.S. dollar-Swiss franc exchange rate expectationsin the mid-1980s to construct measuresof the risk premium as the deviation fromuncovered interest rate parity and alsotaking account of potential simultaneitybias using appropriate instrumental-variable estimation, Dominguez andFrankel (1993b) find that interventionvariables have statistically significantexplanatory power in a regression forthe risk premium. Their study pro-vides strong support in favor of a sig-nificant portfolio balance effect (withmean-variance optimization) and, there-fore, effectiveness of intervention, and

25 Interesting evidence on the relationship be-tween exchange rates, interest rates and currentaccount news is also provided by Costas Karfakisand Suk-Joong Kim (1995), using Australian datafor the period from July 1985 to December 1992.The Australian dollar is found to depreciate overthe sample examined, while interest rates arefound to rise as a result of an announcement of alarger than expected current account deficit.These results may be interpreted as consistentwith the view that market participants expected aforeign exchange market intervention sale of theAustralian dollar by the Reserve Bank of Australiaand they used a portfolio balance model whenresponding to news.


especially coordinated intervention.Their results lead the authors to statethat

Until recently, there was an unusual de-gree of consensus among economists thatintervention by central banks in the foreignexchange market did not offer an effective orlasting instrument for affecting the exchangerate. . . . the theoretical case against the ef-fectiveness of intervention is not as clear asa reading of the economics literature mightsuggest. (p. 1356)

4.3 The Signalling Channel: Evidence

The empirical literature investigatingthe significance of the signalling chan-nel is relatively recent but growing rap-idly, especially due to the release ofdaily data on intervention from the U.S.authorities in the early 1990s. Given thecomprehensive review of the 1980s andearlier literature by Edison (1993), wefocus here—with one exception—onstudies published during the 1990s.

The single exception is the unpub-lished doctoral thesis of Dominguez(1987). This is an empirical investiga-tion of the ability of the monetaryauthorities to signal monetary policy in-tentions and affect market expectationsof the future exchange rate, executedusing weekly U.S. data for the February1977–February 1981 period. Estimationof regressions of the intervention vari-able on money surprises (constructedusing publicly available preannouncedmoney supply forecasts) produces re-sults suggesting that money supply sur-prises are positively associated withintervention during periods of highreputation and credibility of the mone-tary authorities. Also, estimation ofregressions of exchange rate changeson intervention, aimed at testing thesignalling channel hypothesis, suggeststhat in periods of high reputation andheavy sterilized official intervention themonetary authorities are able to influ-ence exchange rate changes, which are

found to be positively related to interven-tion. Overall, this study provides someevidence supportive of the signallinghypothesis.26

Interesting evidence has also beenproduced through the estimation of in-verted portfolio balance equations withthe risk premium as the dependent vari-able, generally under the assumption ofrational expectations (e.g. Dominguez1990). This approach has often beenseen as providing information on theeffectiveness of sterilized interventionthrough the signalling channel ratherthan the portfolio balance channel be-cause the explanatory variable used inthe estimated regression is typicallyactual intervention rather than cumu-lated intervention, the more commonvariable used by the literature. For-mally, the estimated regression is of thefollowing form:

ρt = γ0 + γ1INTt − 1C + γ2INTt − 1

NC + ωt, (8)

where ρt is the risk premium, INTtC and

INTtNC are defined as coordinated and non-

coordinated actual intervention, and ωtis a white noise error. As a repre-sentative study of this literature, forexample, Dominguez (1990) provides re-sults for five subperiods, using daily datafor the Japanese yen-U.S. dollar and theGerman mark-U.S. dollar from January1985 to December 1987. For the first

26 Another important early contribution is dueto Obstfeld (1990). This is an examination of theeffectiveness of foreign exchange intervention af-ter the 1985 Plaza Hotel announcement by the G5countries. At that time, a substantial realignmentof exchange rates occurred and, at the same time,foreign exchange market intervention—mainlyconcerted and sterilized—was undertaken on ascale not seen since the early 1970s. The evidenceproduced indicates that sterilized intervention hadplayed a relatively minor role in promoting ex-change rate realignment, while shifts in the pat-terns of monetary and fiscal policy were the mainfactors determining currency values during thelate 1980s. Similar results are obtained by severalother studies (e.g. see Humpage and WilliamOsterberg 1990; Eijffinger and Noud Gruijters1991a,b).


two subperiods, the estimation producessignificant and correctly signed coeffi-cients on the intervention variables,while in the remaining subperiods thecoefficients are either significant butwrongly signed or correctly signed butnot statistically significantly differentfrom zero at conventional significancelevels. Interestingly, different effectsare found for coordinated and noncoor-dinated intervention for various sub-periods and, in general, the coefficienton coordinated intervention is found tobe relatively more strongly statisticallysignificant.

More recently, Dominguez andFrankel (1993a) employ an alternativeestimation procedure, different from allprevious studies, as they test both chan-nels of influence without assumingrational expectations of exchange rates;indeed, the expected future U.S. dollar-German mark exchange rates used inthe estimation are weekly and biweeklysurvey data on market forecasts. Do-minguez and Frankel estimate a two-equation system where one of theequations defines the expectationsformation mechanism and the otherequation is an inverted portfolio bal-ance equation which allows for mean-variance optimization.27 Also, the esti-mated model allows for all of thefundamentals suggested by traditionalexchange rate determination models asexplanatory variables, thereby providinga more carefully specified reduced formregression for the exchange rate relativeto previous studies. Intervention is de-

fined in three different ways: one-dayintervention (occurring at the end ofthe day before the survey), one-week ortwo-weeks intervention (cumulated be-tween survey forecasts) and cumulatedintervention (cumulated from the be-ginning of the sample period). Theauthors also distinguish, in some ofthe many regressions estimated intheir study, between public and secretintervention.

Overall, the monograph of Domin-guez and Frankel (1993a) providesstrong statistical evidence supportive ofthe effectiveness of sterilized interven-tion through both the portfolio balancechannel and the signalling channel. It isalso shown that, for certain parametervalues and under the two assumptionsthat interest rates are constant and thatexpectations are neither adaptive norextrapolative, the quantitative effects ofsterilized intervention may be substan-tial. These results are arguably the mostsupportive of the effectiveness ofofficial intervention in the relevantliterature. The use of survey data, thebilateral basis of the estimated regres-sion (rather than multilateral), thesample period considered (only data forthe 1980s) and the constraint of mean-variance optimization imposed in theinverted portfolio balance equation allrepresent potential factors that mayhave influenced the findings of Domin-guez and Frankel (1993a), and furtherwork to investigate the specificity oftheir results is therefore warranted.The authors conclude their monographeliciting a view—shared by the presentauthors—characterized by a certaindegree of optimism:

Our results suggest that intervention canbe effective, especially if it is publicly an-nounced and concerted. It may be that steril-ized intervention can only have effects in theshort term. But if “short-term effects” in-clude the bursting of a nine-month bubble

27 More precisely, the expectations formationmechanism is described by an equation where theinvestor’s forecast of the expected future exchangerate is the dependent variable and the explanatoryvariables are the difference between the contem-poraneous and the lagged exchange rate and threedifferent dummies for information on interventionreported in newspapers, actual intervention oper-ated by the Bundesbank, and actual intervention bythe Federal Reserve reported in the newspapers.


earlier than it would otherwise have burst,then such an effect may be all that is needed. . . Our specific recommendations are quitemodest: that the authorities make their inter-ventions public, that an interagency processregularly consider exchange rate develop-ments in light of developments in the funda-mentals, and the G7 discussions on macro-economic policy and exchange rates beintegrated. (p. 140)

In a further complementary study,using survey data on dollar-mark ex-change rate expectations, Dominguezand Frankel (1993c) provide evidencethat official announcements of exchangerate policy and reported interventionsignificantly affect exchange rate expec-tations and that, overall, the effective-ness of intervention, in terms of signifi-cantly affecting both weekly and dailyexchange rate changes, is very muchenhanced if it is publicly announced.28

Using publicly available data on U.S.foreign exchange rate intervention, aninteresting literature examines the rela-tionship between foreign exchange mar-ket intervention and monetary policy,testing the hypothesis that official inter-vention signals changes in future mone-tary policy as well as the hypothesis thatchanges in monetary policy may induceleaning-against-the-wind interventions.This literature provides persuasive sup-portive evidence for both hypotheses,suggesting that official intervention maypredict monetary policy variables andvice versa (e.g. see Lewis 1995 for astudy of the period from 1985 to 1990).This literature also examines theprediction of the signalling channel

hypothesis that central banks signal amore contractionary monetary policy inthe future by buying domestic currencytoday and, therefore, that expectationsof future tighter monetary policy makethe domestic currency appreciate, eventhough the current monetary effects ofthe intervention are typically offset bysterilization. This expectation presumesthat central banks in fact back up inter-ventions with subsequent changes inmonetary policy, and the literature pro-vides ample evidence in favor of thispresumption (Graciela Kaminsky andKaren Lewis 1996).

Another interesting contribution inthis context, due to Catherine Bonser-Neal, V. Vance Roley, and Gordon Sel-lon (1998), re-examines the relationshipbetween the Federal Reserve monetarypolicy actions, U.S. interventions incurrency markets and exchange ratesusing an alternative measure of mone-tary policy actions—the Federal Re-serve’s federal funds interest ratetarget. The authors find that the ex-change rate generally responds immedi-ately to U.S. monetary policy actionsand that this response is usually consis-tent with Rudiger Dornbusch’s (1976)exchange rate overshooting hypothesis.The authors also find evidence ofsignalling and leaning against the windin U.S. intervention policies over thesample period.

A closely related strand of the litera-ture has recently addressed the ques-tion of whether there is a link betweencentral bank intervention and the vola-tility of foreign exchange rates. Bonser-Neal and Glenn Tanner (1996), for ex-ample, examine the effects of centralbank intervention on the ex ante volatil-ity of the U.S. dollar-German mark andthe U.S. dollar-Japanese yen from 1985to 1991, estimating ex ante volatilityusing the implied volatilities of cur-rency option prices and also controlling

28 The literature identifies a number of episodesof coordinated intervention over the 1985–91 pe-riod across the G3 countries (the U.S., Germany,and Japan), all of which may have been successfulin reversing the trend in the dollar, presumablythrough the signalling channel (Pietro Catte,Giampaolo Galli, and Salvatore Rebecchini 1994).For a recent study of intervention in the contextof the European Monetary System, see PeterBrandner, Harald Grech, and Helmut Stix (2001).


for the effects of other macroeconomicannouncements. Bonser-Neal and Tannerfind little support for the hypothesis thatcentral bank intervention is associatedwith a positive change in ex ante exchangerate volatility or with no change.29

More recently, the standard of theanalysis has been raised using intradaydata. The first intraday study of inter-vention is due to Bettina Peiers (1997),who examines Reuters reports of inter-vention in dollar-mark by the Bundes-bank over the period October 1, 1992 toSeptember 30, 1993 and finds thatDeutsche Bank was a “price leader” upto sixty minutes prior to interventionreports. By the time the reportedintervention appears on the Reutersmoney-market headline news screen,one observes two-way causality and the“normal” sort of price interactionsamong traders, implying that interven-tion is signaled via the counterpartybanks used by the central bank. Themarket has learned of the interventionthrough trading rather than the publicnews shown on the Reuters newsscreen. By the time the headline newsscreen reports the intervention, it is nolonger news to the interbank market.Such informational leads should betaken into account by researchers inves-tigating the “news” effects of interven-tion. Yuanchen Chang and StephenTaylor (1998) examine the effects ofintervention by the Bank of Japan againusing intraday data over the sameperiod as that analysed by Peiers (1997)and news related to the Bank of Japanintervention in the dollar-yen marketretrieved from Reuters reports. Theyfind that dollar-yen volatility varies

significantly differently across periodsfrom one before to one after Reuters’intervention reports. Using autoregres-sive conditional heteroskedasticity mod-els, Chang and Stephen Taylor find thattheir intervention proxy has the largesteffect on high frequency volatility 30 to45 minutes prior to Reuters’ reports ofintervention.

4.4 The Secrecy Puzzle

Most actual intervention operationsin the foreign exchange market havebeen—and still are—largely secret, notpublicly announced by monetaryauthorities. This secrecy of officialintervention is difficult to explain,however, given that the signallingchannel is expected to work through al-tering the expectations of other marketagents through policy announcementsby monetary authorities.

The traditional relevant literatureidentifies three types of arguments infavor of secrecy of official intervention:arguments based on the central bank’sdesire to minimize the effects of anunwanted intervention operation (forexample because the decision has beentaken outside the central bank, e.g. bythe Treasury), arguments based on theperceived risk and volatility in theforeign exchange market which mightbe exacerbated by an announcementof official intervention, and portfolioadjustment arguments (Dominguez andFrankel 1993a). A further explanationmay be that although monetary authori-ties intervene in order to target thevalue of a foreign currency, since thefundamentals of the foreign currency arenot necessarily equal to this objective,the monetary authorities do not have anincentive to reveal their interventionoperations and no announcement ontheir activities will be credible (seeBhattacharya and Weller 1997; Vitale1999a,b,c).

29 The link between intervention and exchangerate volatility has also been formally rationalizedin some recent theoretical studies, generally in thecontext of multi-country intertemporal asset pric-ing models (e.g. see Richard Baillie and Osterberg1997).


While some of these arguments mayapply some of the time, none of themseems to explain fully the widespreadpractice of secret intervention opera-tions, and further study is required toanalyze these issues further and im-prove our understanding. As we haveconjectured above, further analysis ofsecond-generation currency crisis mod-els may ultimately shed some light onthis puzzle: secrecy of intervention maybe an attempt to affect the exchangerate through the portfolio balance chan-nel without triggering a self-fulfillingattack on the currency. For the mo-ment, however, the secrecy of muchofficial intervention remains somethingof a puzzle.

4.5 The Empirics of Central BankReaction Functions

The empirical literature on centralbank reaction functions has typicallyreported rather simple functions in anattempt to shed light on the behavior ofcentral banks in the foreign exchangemarket and to test certain theoreticalpredictions concerning intervention.30

While the dependent variable in thesereaction functions is always some mea-sure of official intervention, the ex-planatory variables considered vary acrossstudies. In most cases, however, ex-change rate changes and deviations of theactual exchange rate from its target levelare included. A fairly typical reactionfunction takes the following form:

INTt = β0 + β1(st − stT) + β2∆st

+ ζXt + νt, (9)

where INTt is the amount of interventionat time t, β0, β1 and β2 are scalar parame-ters, Xt is a vector of economic factorswhich may influence official intervention(e.g. lagged intervention or the country’strade balance position), ζ is a corre-sponding vector of parameters, st and st

T

denote the actual and target level of theexchange rate (domestic price of foreigncurrency) at time t (in logarithms), ∆st isthe (percentage) change in the exchangerate, and νt is an error term.31 The signof β1 is expected to be negative if inter-vention is stabilizing in the sense thatthe volume of intervention is inverselyrelated to the deviations of the actual ex-change rate from its target level, whereasβ2 is unconstrained and an estimatednegative (positive) sign indicates that thecentral bank sells (buys) foreign exchange(domestic currency) when the currencyhas depreciated (appreciated), implyingthat the central bank pursues a policy ofleaning against (with) the wind.32

The main results recorded by therelevant literature on estimating reactionfunctions of the form (9) or variants ofit, largely carried out in the 1980s andapplied to some of the central banks ofthe major industrialized nations, may bebriefly summarized as follows:33

30 There is by now a very large and still growingbody of empirical literature on the reaction func-tions of central banks. The literature especiallyfocuses on monetary policy reaction functions or“Taylor rules”—see, for example, Giuseppe Tullioand Marcio Ronci (1997), and Richard Clarida,Jordi Gali, and Mark Gertler (1998, 1999) and thereferences therein. The focus of this section is,however, specifically on reaction functions de-signed to examine exchange rate management.

31 Although some researchers estimate equa-tions like (9) by ordinary least squares, instrumen-tal variable estimation is strongly advised given theendogeneity of the variables in (9).

32 The traditional approach to the estimation ofsterilization equations has often been criticized onvarious grounds. In particular, one may argueagainst the ad hoc specification of the reactionfunction of the monetary authorities typically em-ployed by this literature. An alternative analyticalmodel where the sterilization equations are de-rived from an explicit maximization problemsolved by the monetary authorities would be morerigorous. In such a model, the optimal interven-tion and sterilization policies of the monetaryauthorities are likely to be a function of the differ-ent disturbances hitting the economy and thepreferences of the monetary authorities (e.g. seeRoubini 1988).

33 For a list of the numerous studies in thiscontext see Edison (1993).


a) the Bundesbank’s main objectiveof exchange rate intervention wassmoothing changes in the exchange rateby following a policy of leaning againstthe wind;

b) the Bank of Japan adopted a policyof leaning against the wind and re-sponded more strongly to exchangerate changes than to deviations of theexchange rate from its target level;

c) the Swiss central bank alsoadopted a policy of leaning against thewind and mainly targeted deviations ofthe actual exchange rate from its targetlevel, although both β1 and β2 werefound to be statistically significant andcorrectly signed;

d) the Bank of England intervenedmainly for smoothing exchange ratemovements, but did not target the levelof the exchange rate.34

Note that this strand of the empiricalliterature assumes that central banks tendto sterilize their interventions in the for-eign exchange market. The questionwhether central banks fully sterilize theirintervention operations is, however, alsoaddressed explicitly by some research-ers. The standard approach followed is toestimate a regression with domestic creditor the monetary base as dependent vari-able and changes in net foreign reserves,contemporaneous output gap and infla-tion as explanatory variables.35 The fol-lowing two forms of reaction functionshave been considered and estimated bysome studies in this literature:

∆DCt = µ1∆NFAt + µ2(y − y∗)t

+ µ3πt + ω1t(10)

∆MBt = ν1∆NFAt + ν2(y − y∗)t

+ ν3πt + ω2t(11)

where DCt denotes domestic credit,NFAt denotes net foreign assets, (y − y∗)tis the gap between current output andits natural level, πt denotes inflation,MBt represents the domestic monetarybase, ∆ represents a change in a stock,and ω1t and ω2t are error terms. Informa-tion with regard to the degree of steril-ization used by central banks is providedby estimates of the coefficients µ1 andν1. In particular, the estimated µ1 coeffi-cient is expected to be negative. If it isnot statistically significantly differentfrom –1, sterilization is full, while if it isgreater than –1 and less than zero, ster-ilization is only partial. The interpreta-tion of ν1 is different in the sense thatfull sterilization is consistent with anestimated value for ν1 which is notsignificantly different from zero.

Also, note the econometric difficultyin separately identifying a reactionfunction from private behavior. For ex-ample, equation (10) could be invertedto show the “offset” of domestic mone-tary operations through endogenouscapital flows which affect NFA.36

The relevant empirical literature in-dicates that the Bundesbank has in thepast tended to sterilize at least partiallyforeign exchange intervention opera-tions, although the degree of steriliza-tion varies over time (see the referencesin Edison 1993). Similarly, using Japa-nese data, researchers generally provideevidence suggesting that the Bank ofJapan sterilized its intervention opera-tions, although sterilization is found tobe full in some studies but varying overtime and decreasing during the post-Bretton Woods period in other studies(e.g. Shinji Takagi 1991; Edison 1993).

34 Interestingly, the empirical evidence suggeststhat the response to exchange rate changes isasymmetric for various central banks, and often indifferent directions (see Edison 1993).

35 Again, given the endogeneity of these variables,instrumental variables estimation is required.

36 This issue was first discussed by Pentti Kouriand Michael Porter (1974) in the context of anopen-economy general equilibrium model of inter-national capital flows determination where capitalflows are essentially seen as the mechanism bywhich a domestic excess demand for money isremoved.


More recently, a novel approach toderiving a central bank intervention re-action function has been proposed byAlmekinders and Eijffinger (1996). Inparticular, this is a model of exchangerates that captures generalized autore-gressive conditional heteroskedasticity,such that intervention is allowed tohave an effect on both the mean andthe variance of exchange rate returns.An intervention reaction function is ob-tained by combining the exchange ratemodel with a particular loss function forthe central bank. The estimation resultsof Almekinders and Eijffinger suggestthat both the Bundesbank and the Fed-eral Reserve largely adopted a leaning-against-the-wind policy and have oftenreacted to increases in the conditionalvariance of daily German mark-U.S.dollar returns.37

Overall, therefore, the empirical lit-erature on central bank reaction func-tions provides fairly mixed results andcertainly represents an important po-tential avenue for future research,especially in the light of the greaterdata availability in recent years. Evi-dence to date, however, suggeststhat central banks appear to use

largely a policy of leaning againstthe wind, to react to both changes ofthe exchange rate from the targetand to exchange rate movements, andto sterilize—at least partially—theirintervention operations.38

4.6 Profitability of InterventionOperations as a Test of the Effectiveness of Official Intervention

According to Milton Friedman’s(1953) view on official intervention, acentral bank which is successful in sta-bilizing the exchange rate should makea profit at the expense of speculators,implying that if official intervention isnot profitable it is not effective. This isthe rationale for measuring the profit-ability of intervention as a means ofevaluating the effectiveness of officialintervention.

Empirical studies focusing on theprofitability of intervention operationsare, however, relatively sparse, presum-ably because of the significant difficul-ties encountered in trying to calculateprofits and losses in this context. Re-searchers typically measure centralbanks’ profits from official interventionon the basis of equations of the form:

zt = ∑ k = 1

t fxk(St − Sk)

+ Sk(ik

∗ − ik)∑ j = 1

kfxj

(12)

where zt denotes profits, fxk denotes pur-chases of foreign exchange at time k, Stand Sk are end-of-period nominal ex-change rates (domestic prices of foreigncurrency) at times t and k respectively,and ik and ik

∗ denote the domestic andforeign interest rates respectively at timek. According to equation (12), profits are

37 The evidence on reaction functions of centralbanks in developing countries and transitioneconomies is still very sparse, perhaps because theeconomic and political environment has beenmuch more unstable in these countries and, mostimportantly, because data are less reliable andoften not available. Two studies are, however,worth noting. Ronci and Tullio (1996) find a verystable reaction function for the Central Bank ofBrazil during the high inflation period from 1980to 1993. More recently, Tullio and Victor Natarov(1999) estimate a daily reaction function for theCentral Bank of Russia using daily data for theperiod from October 1, 1996 to October 1, 1997.The authors find a systematic and significant reac-tion of the Bank to changes in market yields, todeviations of the market exchange rate from thecentral rate of the narrow rouble-U.S. dollar cor-ridor, to changes in the regulations concerningrepatriation of foreign capital and to changes inthe differential between yields on taxable andnontaxable Treasury bills.

38 Indeed, this conclusion is consistent with therecent findings by Christopher Neely (2001), whoused survey data based on questionnaires sent tothe monetary authorities of 44 countries.


determined by two factors: (a) the differ-ential between the end of period ex-change rate at time t and the exchangerate at which the foreign currency waspurchased at time k; and (b) the interestrate differential between the two coun-tries whose currencies are involved inthe intervention operation, and hence theinterest rate costs of the intervention.

The empirical evidence provided byresearchers on the profitability of inter-vention in the 1980s, well surveyed byEdison (1993), Richard Sweeney (1997)and Neely (1998), suggests that profitsfrom intervention operations may varysignificantly according to the sampleperiod considered but, in general and inthe long run, central banks make profits.

A general fundamental drawback,however, of this strand of the literatureis concerned with the implicit assump-tion that the profitability of interven-tion represents a valid criterion bywhich to measure the effectiveness ofofficial intervention. As clearly shownby—among others—Edison (1993), it ispossible to think about very realisticsituations in which stabilizing (effec-tive) official intervention may not beprofitable and, vice versa, situations inwhich official intervention may be de-stabilizing but profitable. The argumentis that, if the authorities were to pur-chase foreign exchange when its pricewas low and sell it when its price washigh, then abstracting from interest-rate considerations, intervention wouldbe profitable even if the purchases andsales had no significant effect on ex-change rates. If the central bank canearn profits on intervention that has noeffect on exchange rates, then it is diffi-cult to argue that those profits implythat intervention has a stabilizing effecton exchange rates. In general, there-fore, profitability of intervention is nota test of its effectiveness in movingexchange rates.

Nevertheless, central bank interven-tion losses or profits vary widely, withsome studies reporting substantiallosses, others substantial profits. Inmost cases, however, estimated profitsare not risk-adjusted, although riskadjustment may have a very significanteffect. Also, profit estimates involvetime series which are generally found tobe integrated of order one (hence non-stationary), implying that test statisticsin this context are likely to have non-standard distributions; very few studiestake this factor into account. Estimatesof risk-adjusted profits for the U.S. andthe Swedish central banks, computedallowing for nonstandard distributions,suggest that none of these central bankshad made losses and may even havemade significant profits (see Sweeney1997).

A different but related recent litera-ture focuses on the relationship be-tween central bank intervention andtrading rule profits in foreign exchangemarkets. Studies in this context oftenexamine moving average trading rules,which are utilized in both futures andspot foreign exchange markets to showthat substantial profits can be earnedfor various currencies (Taylor andHelen Allen 1992). Also, central bankintervention is usually found to bestrongly associated with the profitabilityof trading returns for these major cur-rencies and partially explains returns(Andrew Szakmarky and Ike Mathur1997). However, this literature largelyfocuses on investigating whether simplerules used by traders have some predic-tive value over the future movement offoreign exchange rates in connectionwith central bank activity, with themain objective of finding out to whatextent foreign exchange predictabilitycan be confined to periods of centralbank activity in the foreign exchangemarket. The emerging stylized fact


from the relevant literature seems tobe that, after removing periods in whichthe central bank has been particularly activein the foreign exchange market, exchangerate predictability is dramatically reduced(Blake LeBaron 1996).

5. Conclusion: Towards a ThirdChannel of Influence?

Is official exchange rate interventioneffective and, if so, how does it work?

Overall, the evidence on the effec-tiveness of official intervention, througheither the portfolio balance channel orthe signalling channel, is still mixed onbalance, although the more recent lit-erature does suggest a significant effectof official intervention on both the leveland the change of exchange rates.Nevertheless, it is perhaps fair to saythat the studies of the 1990s, which arelargely supportive of the effectivenessof intervention, should perhaps begiven more weight than the studies ofthe 1980s, which largely rejected theeffectiveness of intervention. This isbecause of the removal of the two majorhandicaps characterizing the empiricalstudies of the 1980s, namely the lack ofdata on intervention and the lack of sur-vey data on exchange rate expectations.Thus, the evidence provided by Domin-guez and Frankel (1993a,b,c) and sub-sequent studies using these high-qualitydata seems to us to be sufficientlystrong and econometrically sound toallow us to conclude cautiously thatofficial intervention can be effective,especially if the intervention is publiclyannounced and concerted and providedthat it is consistent with the underlyingstance of monetary and fiscal policy.Nevertheless, further empirical work inthis area is clearly warranted, especiallygiven the increasing availability of high-quality daily data on intervention.

Of the two traditional channels of in-

fluence, it is tempting to conjecturethat the portfolio balance channel willdiminish in importance over time—atleast among the major industrializedcountries—as international capital mar-kets become increasingly integrated andthe degree of substitutability betweenfinancial assets denominated in the ma-jor currencies increases. This suggeststhat, if intervention in the major cur-rencies is effective at all through eitherof the traditional channels of influence,it will in future be effective primarilythrough the signalling channel, particu-larly if it is internationally concerted.39

Another argument for the relativelylesser importance of the portfolio bal-ance channel is that the typical size ofintervention operations is a very tinyfraction of total foreign exchange mar-ket turnover.40 On the other hand, it isperhaps misleading to compare thescale of official intervention to marketturnover, since turnover relates to grossmarket activity, whereas it may be morerelevant to compare the actual or de-sired net change in traders’ end-of-daystock positions. This would certainly bemuch smaller than overall turnover but,unfortunately, we have no measure of it.

39 The view that intervention is most effectivethrough the signalling channel and when it is in-ternationally concerted also appears to be a widelyheld view of policy makers and influential policyadvisors. For example, at a press conference onSeptember 19, 2000, held at the annual meetingsof the IMF and World Bank, Michael Mussa saidthe following of official intervention: “It does tendto be significantly more effective when that inter-vention is coordinated among the major countriesand when those countries, in effect, send the sig-nal that it is their joint judgment that marketshave taken exchange rates substantially away fromfundamentals and that some correction is war-ranted. I think it also tends to be significantlymore effective when there is some signal thatmonetary policy in one or more of the major areasis likely to be supportive of the intervention.”

40 Writing in the early 1990s, Dominguez andFrankel (1993a, pp. 88–89) argue that, at $200million dollars per day, the typical intervention op-eration is dwarfed by the worldwide volume oftrading of some $1,000 billion.


If, however, the signalling channel istaken seriously, then an important“secrecy puzzle” emerges: many actualintervention operations in the foreignexchange market are secret. Given thatthe signalling channel is expected towork through altering the expectationsof other market agents through policyannouncements by monetary authorities,this is something of a puzzle which hasnot yet been adequately resolved in theliterature. We conjectured above thatfurther analysis of second-generationcurrency crisis models may ultimatelyshed some light on this puzzle, in thatsecrecy may reflect an attempt by theauthorities to affect the exchange ratethrough the portfolio balance channelwithout triggering a self-fulfilling attackon the currency. Given our conclusionthat the portfolio balance channel islikely to be of less importance than thesignalling channel and is likely to fur-ther diminish in importance in thefuture, however, this raises the issue ofwhether or not major monetary authori-ties are in fact using the interventiontool optimally. Further work on thisissue is clearly required.

Finally, it is perhaps worth mention-ing a third possible channel of influencefor intervention which has, to date, re-ceived very little attention in the litera-ture. This is through its role in remedy-ing a coordination failure in the foreignexchange market. One way to thinkabout this is as follows. First, the for-eign exchange market may be subject toirrational speculative bubbles broughtabout by important noneconomic fac-tors such as chartist or technical analy-sis which are known to have a signifi-cant effect on the market and whichmay impart swift movements of the ex-change rate away from the level consis-tent with the underlying economic fun-damentals (Frankel and Kenneth Froot1990; Taylor and Allen 1992). Once the

exchange rate has moved a long wayaway from the fundamental equilib-rium, it may be very hard for individualmarket agents to act to bring about areversion of the exchange rate, eventhough they may strongly believe it tobe misaligned, because of a coordina-tion failure. If all of the “smart money”traders were to act simultaneously so asto sell the currency which is overvaluedaccording to the economic fundamen-tals, then the bubble would be pricked.In practice, once the exchange rate getsstuck into a trend—perhaps because ofthe widespread use of trend-followingtrading rules (Taylor and Allen 1992)—it takes a great deal of courage for anindividual trader to attempt to buck themarket. Publicly announced interven-tion operations can here be seen as ful-filling a coordinating role in that theymay organize the “smart money” to en-ter the market at the same time. Thisroute for the effectiveness of interven-tion might be termed the “coordinationchannel.” The mid-1980s dollar over-valuation provides a clear case study ofthe coordination channel: contemporarycommentaries reveal a clear consensusin the dollar overvaluation yet it ap-parently took the publicly announcedPlaza Agreement of the G5 countries tosuccessfully puncture the bubble.

The coordination channel is implicitin Dominguez and Frankel’s (1993a)discussion of intervention, and belief inits importance appears to form an im-portant part of policy makers’ views onintervention (see e.g. Sushil Wadhwani2000; Stephen Cecchetti, Hans Gen-berg, John Lipsky, and Wadhwani2000). Nevertheless, it has receivedscant attention in the academic litera-ture to date. In our view, further theo-retical and empirical work on the co-ordination channel is likely to be a veryimportant avenue for future research inthis area.


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Official Intervention in the Foreign Exchange Market: Is ... · Taylor (1982), Dominguez and Frankel (1993a), Hali Edison (1993), Keith Pilbeam (1991), and Geert Almekinders (1995)