Working Paper: CEPR ID: DP504
Authors: Giuseppe Bertola; Ricardo J. Caballero
Abstract: Recently developed models of exchange rate dynamics emphasize the expectational effects of infrequent intervention. This paper proposes a stylized probabilistic framework in which such effects can be studied along with realistic concerns about the sustainability of the intervention policy. In this framework, the level of reserves determines the extent to which non-linear intervention affects the level of exchange rates and their sensitivity to movements in fundamentals. We show that all such effects are absent when the possible reserve levels are weighted by their long-run probabilities.
Keywords: exchange rates; target zones; reserves; sustainability of intervention
JEL Codes: 431; 432
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| cumulative interventions (C32) | probability of realignment (D79) |
| reserves are plentiful (Q35) | likelihood of defending exchange rate against depreciation (F31) |
| reserves dwindle (Q31) | likelihood of validating expectations of devaluation (F31) |
| low reserves (Q30) | likelihood of downward jumps in exchange rates (F31) |
| high reserves (F31) | likelihood of upward jumps in exchange rates (F31) |
| long-run relationship between fundamentals and exchange rates resembles freely floating exchange rate (F31) | nonlinearities induced by intervention cancel out over time (C22) |
| decreasing reserves (Q31) | convex function of relationship between exchange rates and fundamentals (F31) |
| long-term expectations (D84) | linear relationship between exchange rates and fundamentals (F31) |