Working Paper: CEPR ID: DP737
Authors: Utpal Bhattacharya; Paul Weller
Abstract: Using a portfolio balance model of exchange rate determination, this paper develops a theoretical explanation of why central banks do not make precise announcements of their exchange rate targets. In foreign exchange markets, where it is common knowledge that the central bank intervenes to stabilize the spot exchange rate around some target level, foreign exchange traders can exploit this fact to earn speculative profits from the central bank: this may cause the bank's reserves to fall to dangerous levels. We show that if the central bank is imprecise about its exchange rate targeting, it can use this informational advantage not only to reduce its reserve losses, but also to extract all relevant `fundamental' information from the traders. The imprecision, however, cannot be too large. There exist circumstances where the central bank finds it advantageous to reduce the market's ex ante uncertainty about the exchange rate target.
Keywords: Central bank intervention; Speculation; Exchange rate; Target zones
JEL Codes: E58; F31; G15
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Central Bank's imprecision in targeting (E52) | Reduced reserve losses (G33) |
| Central Bank's imprecision in targeting (E52) | Enhanced information gathering (D83) |
| Central Bank's interventions (E52) | Increased exchange rate volatility (F31) |
| Central Bank's targeting objective (E52) | Effectiveness of interventions (I24) |