Academic journal article International Advances in Economic Research

Central Bank Intervention, the Current Account, and Exchange Rates

Academic journal article International Advances in Economic Research

Central Bank Intervention, the Current Account, and Exchange Rates

Article excerpt

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 longrun 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. (JEL F31)

Introduction

This paper seeks to explain exchange rate and current account behavior under central bark foreign exchange rate intervention. Some basic forms of intervention include targeting an appropriate level for the domestic currency; attempting to preserve orderly market conditions; and concerted intervention by several central banks, as witnessed by the support of the Euro over 2000 and 2001. The object of intervention is to influence movements in exchange rates, and the capital and current accounts of the balance of payments (1) for policy purposes. To analyze central bank intervention we use the current account-net foreign assets identity, as well as the long-run monetary exchange rate model (MM). 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 nonlinear function exchange rates determine the current account, and the current account in turn determines exchange rates. The first (reminiscent of the traditional elasticity approach), shows a causality link from the exchange rate to trade, while the second (used in Portfolio Balance Models) shows an opposite and concurrent relationship: that changes in the current account will lead to changes in the exchange rate.

Section one shows a brief and very limited exposition of PBM's and the monetary model. This is followed by a discussion in section two of the coexistence of movements in exchange rates, and current account imbalances. This is explained by short-run exchange rates deviating from, or being equal to their long-run equilibrium. Section three develops a model of the joint functionality of the current account and exchange rates, and sections four and five respectively discuss real exchange rates and the effectiveness of central bank intervention.

Open Economy Models

First and Second Generation Portfolio Balance Models

Portfolio Balance Models are approaches to open-economy analysis that have gained broad acceptance in the last three decades. Of consequence to our discussion are limitations of PBM's in explaining current account-exchange rate interactions, and their ensuing lesser adequacy in intervention analysis2 than the less complex and more limited monetary model.

First generation PBM's assume perfect (or near perfect) capital mobility which clears financial asset markets and determines the value of the exchange rate. Examples of these models are Mundell [1962], and Dornbusch [1976]. …

Search by... Author
Show... All Results Primary Sources Peer-reviewed

Oops!

An unknown error has occurred. Please click the button below to reload the page. If the problem persists, please try again in a little while.