Effectiveness of FX intervention and the flimsiness of exchange rate expectations

Hernando Vargas-Herrera and Mauricio Villamizar-Villegas

Journal of Financial Stability, 2024, vol. 74, issue C

Abstract: Most of the foreign exchange intervention literature overlooks the influence of market uncertainty when evaluating effectiveness. In this paper we take a fresh new look at how this uncertainty amplifies exchange rate effects. Our contribution is twofold. We first posit a partial equilibrium model with frictions to illustrate that when uncertainty is low, intervention is less effective, for agents are willing to bet against the central bank. Conversely, when uncertainty is high, intervention faces a weaker countervailing force from speculators and arbitragers. Second, we empirically test for the incremental effects of flimsy exchange rate fundamentals by using a sharp policy discontinuity in the way the Central Bank of Colombia intervened in the FX market. Our results indicate that market uncertainty increases depreciation of domestic currency in approximately 2 percentage points (pp) following central bank purchases of foreign currency and extends its duration in up to 4 weeks. Additionally, these purchases have an incremental effect in curbing exchange rate volatility in close to 5 pp.

Keywords: Sterilized FX intervention; Exchange rate uncertainty; Policy discontinuity; Incremental effect of intervention; Regression Discontinuity Design (search for similar items in EconPapers)
JEL-codes: C14 C31 E58 F31 (search for similar items in EconPapers)
Date: 2024
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Citations: View citations in EconPapers (4)

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Related works:
Working Paper: Effectiveness of FX Intervention and the Flimsiness of Exchange rate Expectations (2019)
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Persistent link: https://EconPapers.repec.org/RePEc:eee:finsta:v:74:y:2024:i:c:s1572308920301169

DOI: 10.1016/j.jfs.2020.100813

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