Central bank intervention, the current account, and exchange rates

Maurice Larrain

International Advances in Economic Research, 2003, vol. 9, issue 3, 196-205

Abstract: This paper seeks to explain exchange rate and current account or net foreign assets behavior under central bank foreign exchange rate intervention. To analyze central bank intervention we use the current account-net foreign assets identity, as well as the long-run monetary exchange rate model. The intervention function is one where exchange rate deviations from equilibrium are governed by nonlinear adjustments. That is, exchange rate deviations from their long-run equilibrium are such that the degree of reversion towards equilibrium increases with the size of the deviation from equilibrium. In this type of nonlinear function exchange rates determine the current account, and the current account in turn determines exchange rates. This iterative duality contrasts with several portfolio balance models where exchange rates are a function of trade, but trade is not a function of exchange rates. This two way causality is slightly more complex, but is also analytically richer than assuming that exchange rates change solely in a one step process as targeted by central banks. Managing exchange rates is posited to be an active iterative feedback process where intervention changes the current account, which may in turn make further intervention necessary. Copyright International Atlantic Economic Society 2003

Date: 2003
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DOI: 10.1007/BF02295443

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