Working Paper: NBER ID: w0963
Authors: Maurice Obstfeld
Abstract: When the goals of internal and external macroeconomic equilibrium are in conflict, sterilized intervention in the foreign exchange market may provide an independent policy instrument through which the central bank can resolve its dilemma in the short run. This paper is concerned with the West German Bundesbank's use of sterilization during the recent years of exchange- rate flexibility. The paper asks whether the Bundesbank pursued sterilization during the years 1995-1981, and whether sterilized foreign exchange intervention exerts a significant influence on the exchange rate in the German case. Estimation of a stylized Bundesbank reaction function suggests an affirmative answer to the first of these questions. To assess the efficacy of sterilized intervention, a structural portfolio balance model of German asset markets and prices is estimated. Dynamic perfect-foresight simulations of the empirical model are used to ascertain whether imperfect substitutability between foreign and domestic bonds is sufficient to allow the Bundesbank to attain independent internal and external goals over the short run of about a month. The model's verdict is that the Bundesbank has little if any power to influence the exchange rate over that time span without altering current or expected future money-market conditions.
Keywords: Exchange Rates; Inflation; Sterilization; Bundesbank; Germany
JEL Codes: E42; E52; F31
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Changes in foreign reserves (F31) | Domestic credit policies (E51) |
| Output gaps (E24) | Domestic credit policies (E51) |
| Sterilized foreign exchange intervention (F31) | Exchange rate (F31) |
| Transitory change in monetary base (E50) | Exchange rate (F31) |
| Reserve changes (F31) | Domestic credit policies (E51) |