Foreign Exchange Intervention: Theory and Evidence.

In the post-cold war era, the global financial marketplace is constantly evolving. The global community is increasingly embracing the principles of the free market system in order to improve its standard of living. During the reconstruction period, some exchange rate volatility is unavoidable. For the stability of the global exchange rate markets and for the optimal use of the world's scarce resources, a closer cooperation among countries on monetary, fiscal, and trade policies is warranted. Isolated domestic policies with disregard to global consequences, however beneficial in the short run, may lead to irreparable economic disaster.

The subject matter of this book is timely and the information contained in this book is indispensable for academicians, practitioners, and policymakers. It is a welcomed addition to the literature on foreign exchange interventions. Utilizing daily intervention figures from the Bundesbank and the Federal Reserve System, the author presents the facts with clarity and offers thought-provoking insightful analysis of the game strategies adopted by the central banks and rational market participants. The study is particularly important in that it utilizes confidential and publicly unavailable daily intervention data of the Bundesbank. The rational speculators would negate the potential impact of foreign exchange interventions. The marketplace is distorted by interventions that produce inefficiencies with asymmetric information. To what extent can market participants be assumed to be rational under such interventions?

Within the framework of the free market system, disequilibriums are short-term phenomena. The forces of demand and supply eliminate market distortions through a self-correcting price adjustment mechanism. Government interventions create, rather than solve, the disequilibrium problems for financial and real sectors of an economy. Central bank interventions do not solve disequilibrium problems of foreign currency markets. In spite of the historical evidence against intervention, central banks continue to intervene in foreign currency markets. The author offers some explanations for such foreign exchange interventions.

The results of the theoretical models are supplemented through rigorous empirical studies. The endnotes of each chapter provide crucial information to readers. The study is comprehensive and well-documented with an exhaustive list of references. The author provides a European perspective on the Fed's exchange rate policies in comparison to those of the Bundesbank's.

The book consists of eight chapters and is based on the author's own previous published research work. Chapter 1 provides an excellent overview of the current floating exchange rate system and of the history of the Bretton Woods fixed exchange rate system that was abandoned in the early 1970s. The author defines and analyzes the effects of intervention.

Chapter 2 presents various theoretical models on foreign exchange intervention (sterilization and non-sterilization). In addition to the flow approach and asset-market approach to exchange rate determination, the chapter examines some alternative approaches to the study of intervention. The chapter provides a critical analysis of the purchasing power parity model, Mundell-Flemming model, flexible-price monetary model, sticky-price monetary model, portfolio balance model, stock-flow portfolio model, near-rationality model, and the chartist channel and noise trading signaling channel. The contributions of prominent scholars on foreign exchange intervention are thoroughly examined. These joint and independent studies include the works of: S. W. Black, A. Blundell-Wignall and P. R. Masson, W. Branson, S. Djajic and S. Bazzoni, R. Dornbusch and S. Fischer, J. Fleming, P. de Grauwe, P. Hallwood and R. McDonald, R. Moreno and N. Yin, R. A. Mundell, F. Natividad and J. Stone, and K. Pilbeam. The theoretical models examine the interwoven nature of the various economic variables such as exchange rate, price level, money supply, velocity of money, real income, demand for domestic goods, private sector real absorption, trade balance, government spending, real money demand, and capital account balance. The intervention models account for the stock of net foreign assets of the domestic economy, net foreign assets of the domestic private sector, net foreign assets held by the domestic central banks, stock of domestic assets of the central banks, and central bank purchases of foreign currency and domestic bonds. Intervention may be effective under inefficient market conditions regardless of the level of substitutability of bonds.

Chapter 3 presents a survey of empirical studies of the objectives and effectiveness of the intervention. The author has attempted to fill a large void by making use of the confidential daily intervention data from the Bundesbank. The objectives of the intervention can be classified into two groups: time-based (short-term or long-term) and division-based (smoothing interventions, trend-breaking interventions, direction-indicating interventions, and reserves-management interventions). Most of the studies on the objectives of the intervention utilize the ordinary least squares estimation technique, while others have utilized the two-stage least squares or the instrumental variable estimation techniques in order to reduce the simultaneity bias. The central banks may not react symmetrically under rising and declining value of their currencies. The author presents a judicious analysis of the policy-related asymmetries. The exogenous changes in the values of numerous other independent variables could accelerate or retard the effectiveness of foreign exchange interventions.

Chapters 4 and 5 provide an in-depth study of the objectives of daily intervention in the DM/$ market by the Bundesbank and the Federal Reserve System, using the generalized autoregressive conditionally heteroskedastic (GARCH) and Tobit models. The author investigates the intervention reaction functions, exchange rate policy, and the conditional variance of the daily DM/$ rate. To help clarify the intricacies of the exchange rate returns, the author provides an analysis of the random-walk model with drift and a GARCH error term. The author also presents an amended GARCH model and introduces a loss function for the central banks. The two central banks, the Bundesbank and the Federal Reserve, do adopt policy measures in an attempt to reduce exchange rate uncertainty.

Chapter 6 presents some additional theoretical models, simultaneity problems between exchange rates and intervention, and empirical estimates of the effect of intervention on the level of the DM/$ rate. Chapter 7 introduces a positive theory of intervention. The central bank interventions are analyzed from various game-theoretic angles: deterministic game against nature, stochastic game against nature, and game against rational market participants. There is a sequence of actions and reactions among various groups of market participants and the central banks. The book presents an amended random-walk model of the exchange rate and analyzes the bandwagon effects. Is there a negative correlation between central bank independence and the average volume of intervention? Does the variance of the volume of intervention decrease with an increase in the level of central bank independence? The issues pertaining to the unequal status of game participants and information asymmetries are examined. The author provides some insightful concluding remarks in Chapter 8. The coordination and cooperation among countries, rather than confrontation, will lead to a greater global economic stability.

The author has adopted a well-balanced approach to theoretical modeling and hypothesis testing through empirical studies. The book can be used as a textbook for the graduate level courses in international finance and multinational business. The book will also serve as a resourceful guide to policymakers and private market participants in their respective planning processes.

Kashi Nath Tiwari Kennesaw State College