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Foreign Exchange
Intervention:
An Empirical Assessment
with Kathryn M.
Dominguez

16.1

Introduction

Can intervention policy effectively influence market expectatons of current
and future foreign exchange rates? The conventional wisdom offers an
unequivocal answer. Intervention in the foreign exchange market has little
or no effect except to the extent that it implies changes in countries'
money supplies. In the latter case, intervention is just a particular variety of
monetary policy. The conventional wisdom thus says that intervention
does not offer the authorities an independent policy tool for influencing the
foreign exchange market.
In the early 1980s, the belief that intervention was not an effective
policy tool was widely shared among academic economists, central bank
ers, and market participants. In the first Reagan administration, the ineffec
tiveness of intervention was an article of faith, and the U.S. government
accordingly refrained from buying or selling foreign exchange (with some
minor exceptions). In 1985, however, attitudes at the U.S. Treasury shifted
abruptly. The U.S. authorities began to intervene again in the markets, in
collaboration with other country's central banks, most visibly as decided at
the meeting of G-5 economic leaders at the Plaza Hotel in September of
that year. Since that time, intervention has taken place regularly. Foreign
exchange traders have taken note of it. They are observed to react to
reports of intervention as vigorously as to any other sort of news. Most
traders, and most involved central bankers, believe that this intervention
has at times had important effects. We believe that the time is right for a
reconsideration of the conventional wisdom as to the ineffectiveness of
foreign exchange intervention.
In this chapter we examine the two possible channels through which
intervention can influence the foreign exchange rate: the portfolio and the

Exchange Rate Expectations

328

expectations channels. Intervention can influence exchange rates through
the portfolio channel provided foreign and domestic bonds are considered
imperfect substitutes in investors' portfolios. Intervention operations that,
for example, increase the current supply of mark relative to dollar assets,
which private investors are obliged to accept into their portfolios, will
force a decrease in the relative price of deutsche mark assets.1 Intervention
can also influence exchange rates, regardless of whether foreign and do
mestic bonds are imperfect substitutes, through the expectations channel The
public information that central banks are intervening in support of a cur
rency (or are planning to intervene in the future) may, under certain condi
tions, cause speculators to expect an increase in the price of that currency
in the future. Speculators react to this information by buying the currency
today, bringing about the change in the exchange rate today.
While some previous empirical studies of foreign exchange intervention
operations have found evidence from daily data that central banks have
had a statistically significant effect on exchange rates (Loopesko 1984;
Dominguez 1990, 1992), the studies were not able to distinguish whether
the effect was coming through the portfolio or the expectations channel.
The goal of this study is to disentangle the influence of the two potential
channels during the most recent experience with central bank intervention
operations.

16.2

Intervention Policy in Practice

Intervention operations by central banks involve the purchase of foreign
assets with domestic assets (or sale), which, if not sterilized will result in an
increase (or decrease) in the domestic monetary base. For example, when
the Fed intervenes against the dollar, the Fed's portfolio of foreign assets
(typically deutsche mark and yen-denominated assets) increases while its
dollar deposits decrease. At the same time, dollar deposits of commercial
banks at the Fed increase. As a consequence, the U.S. monetary base (com
mercial bank deposits at the Fed plus currency in circulation) is increased.
The Fed can sterilize this increase by selling the appropriate number of
dollar-denominated assets in open-market operations.
The Federal Reserve Bank of New York reportedly fully and auto
matically sterilizes its intervention operations on a daily basis. In practice,
the foreign exchange trading room immediately reports its dollar sales to
the open market trading room, which then buys that many fewer bonds, so
that the daily money supply is unaffected. The Bundesbank also claims to

Foreign Exchange Intervention

3 29

sterilize its foreign exchange intervention operations routinely as a techni
cal matter. Nevertheless, the general view is that both banks have at times
allowed intervention operations to influence monetary aggregates. The
degree of monetary accommodation is, however, limited, to the extent that
they both target money supply growth. In this chapter we do not concen
trate on the distinction between sterilized and nonsterilized intervention.
We study the intervention operations that actually took place between
1982 and 1988, regardless of whether they were sterilized.
Central banks have not routinely made daily intervention data avail
able to the public. Quarterly data on monetary authorities' international
reserves are available both from central bank publications and the Interna
tional Monetary Fund's International Financial Statistics. Quarterly changes
in these data have commonly been used by researchers as proxies for
intervention flows.2 These data, however, can differ significantly from ac
tual official purchases of foreign exchange in the open market. The level of
a country's reserves can change even if the central bank does not transact
in the foreign exchange market. Reserves increase with interest accruals on
offical portfolio holdings and fluctuate with valuation changes on existing
nondollar reserves.
Apart from the fact that reserve data do not provide good approxima
tions to official intervention activity, quarterly and monthly data obscure
important daily information. Intervention operations are implemented on a
minute-to-minute basis. Net daily intervention information at a minimum is
necessary for study of intervention's effects. Data on daily official central
bank purchases and sales in the foreign exchange market have rarely been
made available to researchers outside the government.3
The U.S. Treasury has recently agreed to change its long-standing
policy and has allowed the Board of Governors of the Federal Reserve
System to make its daily intervention data publicly available, with a oneyear lag. At this time none of the other G-7 central banks has a general
policy of releasing its intervention data to the public. We are fortunate
to have available for purposes of this study, in addition to the recently
released Fed data, daily Bundesbank intervention data from 1982 through
1988.
Although contemporaneous intervention operations are not published
on a daily basis by the central banks, daily intervention operations are
frequently reported in newspapers and over the wire services. So although
current official data are unavailable, there exist numerous unofficial sources
of the data. How do traders and reporters learn about intervention opera

330

Exchange Rate Expectations

tions? Although each central bank has its own particular set of practices,
they generally undertake intervention directly with the foreign exchange
desk of a large commercial bank. As with any other foreign exchange
transaction, trades are officially anonymous. If the Fed decides to intervene
in support of the dollar, the Fed trader can either call a broker or deal
directly with another trader at a commercial bank to place an order for
dollars. If the Fed would like the market to know the source of the dollar
purchase, the Fed trader will call one of a number of selected commercial
banks that the Fed traditionally does business with. Unless the Fed trader
says otherwise, the bank trader will understand that not only does the Fed
want to purchase dollars but that it would like the market to know this.
This information is reportedly disseminated among traders in the market
within minutes of the original Fed call.
Given the speed at which information flows in the foreign exchange
market, more remarkable than the revelation of intervention operations are
the occasions when operations are kept secret. In the U.S. case, the Fed is
more likely to intervene secretly through the broker market, although it
can also do so using a commercial bank with which it does not traditionally
do business. The Fed also, on occasion, intervenes secretly through the
major banks with which it traditionally does business. In any case, if the Fed
trader says that the intervention operation is to remain secret, then the
broker or bank trader has an incentive not to disclose the Fed's presence in
the market if he or she ever wants to be privy to future intervention
information and business.
What is the relative frequency of "secret" interventions? Secret interven
tions are not differentiated in central banks' official data, but one can
roughly infer which operations were secret by comparing the official data
with published reports of intervention activity in the financial press. Al
though traders may sometimes know that central banks are intervening
without its showing up in the financial press, this relatively conservative
accounting for reported intervention reveals that the bulk of recent inter
vention is not secret.4 In the econometric analysis to follow, we include
secret and reported intervention separately in order to determine whether
the distinction is important.

16.3 A Two-Equation System: The Portfolio and Expectations
Channels
The traditional theoretic explanation for how intervention operations in
fluence exchange rates is based on the portfolio balance approach to

Foreign Exchange Intervention

331

exchange rate determination. The central assumption is that foreign and
domestic bonds are imperfect substitutes for each other in investors' port
folios. Investors hold both foreign and domestic bonds in their portfolios
and optimize a function of the mean and variance of their end-of-period
wealth.5 The monetary authority can influence the relative prices of for
eign and domestic bonds by changing their relative supply in investors'
portfolios. For example, if the Fed increases the relative supply of dollardenominated bonds in the market then investors will demand a dollar
risk premium to compensate them for the risk that they bear holding the
additional dollar assets.
The first equation in our two-equation system is a modified version of
the traditional portfolio-balance model. (We introduced this form of the
equation in Dominguez and Frankel 1993.) The main modification relative
to the previous literature is that we assume that exchange rate expectations
can be measured more precisely using survey data than by assuming ratio
nal expectations and using ex post changes in the exchange rate. Intu
itively, the equation lets the expected risk premium on mark-denominated
assets depend on the relative quantity of mark-denominated assets in inves
tors' portfolios.
if f

“

* * *

A s * *

& >

P i vt

P 2 v tx t

u t ,k

where i f f is the /c-period-ahead EuroDM interest rate, i*k is the fc-periodahead eurodollar interest rate, Aste k is the expected change in the spot rate
between period t and t + k measured by the survey data, v, is the daily
variance of exchange rate changes over the preceding week, xt is the share
of mark-denominated assets in investors' portfolios, and the error term, ut k,
reflects any measurement error in the data. If the sole (random) measure
ment error occurs in the survey data, OLS estimates of (1) will be appropri
ate. However, if the asset data are measured with error or if asset demands
are given by the mean-variance specification plus an error term, then the
regression will be subject to simultaneity bias and (1) should be estimated
using instrumental variables. We do both.
The second equation in the two-equation system is our expectations
equation. Regardless of whether the portfolio balance channel is operative,
intervention operations may influence exchange rates if they provide rele
vant news to market participants.6 The expectations equation therefore lets
the change in investors' expectation of the future exchange rate be a func
tion of past changes in the spot exchange rate and intervention policy
news.

Exchange Rate Expectations

332

(S,% -

= a0 + «i(5. - s,-j) + a2(s, - s'e_M )
-f a 3ANNOCt + oc4REPINTt + oc5SECINTt + e,

(2)

where (sf% — s/L,- k) is the revision in the log of the MMS survey prediction
of the k-period ahead dollar/mark spot rate from time t — j to time t, st_j is
the log of the spot rate on the day of the last MMS survey, ANNOC, and
REPINTt are (1,0, — 1) dummy variables that capture reports of exchange
rate policy news since the last survey date, SECINTt is a (1,0, — 1) dummy
variable for nonreported intervention operations since the last survey date,
and e, is the error term.7
Our specification of the expectation equation is general in that it allows
for both extrapolative and adaptive expectations. At the four-week hori
zon, respondents have been observed to put negative weight on the lagged
spot rate and more-than-unit weight on the contemporaneous spot rate, so
that they are extrapolating the recent trend into the future to get their
forecast.8 Our extrapolative parameter is
Bandwagon expectations are
the special case <xl > 0 and a 2 = 1. Previous work has also found evidence
that respondents form their predictions adaptively, putting positive weight
on the lagged survey prediction (Frankel and Froot 1987, reproduced here
as chapter 13). Our speed-of-adaptation parameter is (1 — a2). Adaptive
expectations are the special case olx = 0 and a2 < 1. Static expectations
are the special case ol1 = 0, a2 = 1. Expectations are stabilizing overall if
<*i + a2 < 1, and destabilizing overall if
+ a 2 > 1.
We also include two news variables in our expectations equation in
order to capture information appearing in the newspaper about changes in
central banks' exchange rate policy since the last survey date. ANNOQ is
set equal to + 1 if there were central bank announcements in support of the
dollar (including, for example, announcements of G-7 meetings to deal with
dollar weakness), —1 if there were official announcements against the
dollar, and 0 if there were no such announcements. REPINTt is set equal to
+ 1 if there were reports of central bank intervention in support of the
dollar, — 1 if there were reports of intervention against the dollar, and 0 if
there were no such reports. The fifth independent variable included in the
regression is secret intervention, denoted SECINTt. SECINTt is set equal to
+ 1 if there were no reports of intervention when a central bank in fact
intervened in support of the dollar, — 1 if interventions against the dollar
were not reported, and 0 otherwise. We expect the two news variables,
ANNOCt and REPINT, to have a negative effect on expectations of the

Foreign Exchange Intervention

333

future dollar/mark rate. If nonreported intervention is truly secret, we ex
pect the coefficient on SECINTt, oc5, to be zero.
The survey data used in both the portfolio balance and expectations
equations are four-week-ahead survey forecasts of the mark-dollar ex
change rate conducted by Money Market Services, International, for the
period October 24, 1984 to December 30, 1988.9 Unlike some other sur
veys, it is conducted on a weekly basis (since July 1985; before that it was
conducted every two weeks). In addition, we report results for an earlier
period November 17, 1982, to October 10, 1984, when the survey per
tained to three-month ahead forecasts. One might expect that intervention
would have a greater effect in the later period, since the Reagan administra
tion's firm commitment to free-floating began to waver when Donald
Regan and Beryl Sprinkel were succeeded at the Treasury by James Baker
and Richard D arman in January 1985, and when the Plaza Agreement
followed in September.
The intervention data series measure consolidated daily official foreign
exchange transactions in millions of dollars at current market values. Posi
tive values denote purchases of dollars and negative values denote official
dollar sales. The Fed data distinguish between interventions against the
mark and the yen and exclude so-called passive intervention operations.
Passive interventions are Fed purchases and sales of foreign currency with
customers who would otherwise have dealt with market agents.10 The
Bundesbank data exclude nondiscretionary interventions required by rules
of the European Monetary System.
The daily intervention data provided by the central banks measure
official net purchases or sales of dollars in the foreign exchange market.
Central bank interest payments and receipts on reserve assets are not
included in the data. Intervention is measured in three ways in these
regressions. One-day intervention is Fed and Bundesbank purchases of
dollars on the day before the survey. Two-week or one-week intervention
is cumulated between survey dates, so that it measures total Fed and
Bundesbank dollar purchases since the last survey. Cumulative intervention
is cumulated from the beginning of the sample period and therefore mea
sures the relative stock supplies of outside assets denominated in dollar and
mark currencies.
Equations (1) and (2) make up our two-equation system. The two endo
genous variables are the current period spot rate and survey expectation of
the future spot rate. We are able to deal with the potential simultaneity

Exchange Rate Expectations

334

problems in both equations by using the exogenous variables from each
equation as instruments for the other equation. The instruments for equa
tion (1) include last period's spot exchange rate, st_jf last period's survey
expectation of the future spot rate, sf_M, and the news variables, ANNOC,
and REPINTt, from equation (2). The instruments for equation (2) include
the variance of spot changes since the last survey date, vt, and the total
quantity of marks sold in foreign exchange intervention (measured in
marks), xv from equation (1).

16.4

The Estimation Results

Table 16.1 presents the expectations equation regression results for the
early sample period. News reports appear to have had no effect on expectaTable 16.1
Sample: November 1982-O cto b er 1984
(5,% - s/-,.*) = a 0 + a i(5r - *t-j) + 0L2(st — s7_,.k) + a3ANNOCt + a^REPINT, +
<x5SECINTt -I- e,
Biweekly three-month-ahead survey expectation equation (Obs = 54, k = 90, j = 14)
instruments: vt, IDM\
One-day*

Cumulative*

Two-weekb

<*0

0.005

(0.006)

0.006

(0.006)

0.008

(0.008)

0.414

(0.400)

0.328

(0.367)

- 0 .0 6 9

(0.609)

«2

0.406

(0.210)t

0.420

(0.217)f

<*3

- 0 .0 0 2

(0.008)

0.002

(0.007)

a4
<*5

x2(D

- 0 .0 0 1

(0.004)

0.432

(0.279)

- 0 .0 0 5

(0.010)

-0 .0 0 2

(0.008)

0.003

(0.006)

0.008

(0.009)

(0.004)

0.003

(0.006)

- 0 .0 0 1

7.990’ *

7.177**

4.123*

X 2d )

7.822**

9.272**

1.984

D.W.

2.09

2.05

1.90

0.72

0.70

0.51

a. Intervention instrumental variable {ID M ) is measured at the end-of-day prior to the
survey.
b. Intervention instrumental variable is an accumulated measure between survey forecasts.
c. Intervention instrumental variable is an accumulated measure from the beginning of the
sample period.
Note: Standard errors are in parentheses. f denotes significance at the 90% level;
* denotes significance at the 95% level; ” denotes significance at the 99% level.
The * 2(1) statistic pertains to the hypothesis that a2 = 1 (expectations are not adaptive);
and x 2U) pertains to the hypothesis that ot, = <x2 = 0 (expectations are not extrapolative,
but are completely adaptive).

Foreign Exchange Intervention

335

tions in the early period 1982 through 1984. However, the instrumental
variable estimates for the same regression over the 1985-1988 subperiod,
presented in table 16.2, indicate a marked change in regime. The coeffi
cients on the news variables appear with the correct sign and are statisti
cally significant in all the regressions for the latter sample: newspaper
reports of exchange rate policy announcements and central bank interven
tion in support of the dollar tend to lower expectations of the future
dollar/mark exchange rate. The average effect of reported intervention on
the one-month ahead expectations of the dollar/mark exchange rate ranged
between .4 and .6 percent. The effect of other official announcements was
twice as large, ranging between .9 and 1.1 percent.
In table 16.2 the coefficient on the lagged spot rate, —a 1# and the
coefficient on the lagged expectation, (1 — a2), are each statistically differ
ent from both zero and one. In other words, there is evidence of extraTable 16.2
Sample: October 1984-D ecem ber 1988
(st% — st-jtk) = a 0 + a x{st — st.j) + a2(sf — sfe_M ) +
a sSECINTt + e,

ol3ANNOC,

Weekly one-month-ahead survey expectation equation (Obs
instruments: vt, ID M \
One-weekb

One-day*

olaREPINT,

186, k

30, j = 7)

Cumulative'

0.005

(0.001)**

0.006

(0.001)**

0.005

(0.001)**

0.394

(0.194)*

0.442

(0.219)*

0.146

(0.253)

0.559

(0.116)**

0.626

(0.116)**

0.478

(0.134)**

<*3

- 0 .0 0 9

(0.002)**

- 0 .0 0 9

(0.002)**

- 0 .0 1 1

(0.003)**

-0 .0 0 5

(0.002)**

-0 .0 0 4

(0.002)*

- 0 .0 0 6

(0.002)**

<*o

<*5

0.005

(0.003)

0.005

(0.003)

0.007

x 2(D

14.362**

10.379**

15.144**

X2 (2 )

17.821**

18.724**

6.599**

D.W.

2.24

2.23

2.10

0 .67

0.67

0.61

(0.003)*

a. Intervention instrumental variable (ID M ) is measured at the end-of-day prior to the
survey.
b. Intervention instrumental variable is an accumulated measure between survey forecasts.
c. Intervention instrumental variable is an accumulated measure from the beginning of the
sample period.
Note: Standard errors are in parentheses. * denotes significance at the 95% level;
” denotes significance at the 99% level. The * 2(1) statistic pertains to the hypothesis
that ot2 = 1 (expectations are not adaptive); and * 2(2) pertains to the hypothesis that
a , = a 2 = 0 (expectations are not extrapolative, but are completely adaptive).

336

Exchange Rate Expectations

polative behavior and gradual adaptation. Overall, expectations are neither
stabilizing nor destabilizing.
Tables 16.3 and 16.4 present the portfolio equation regression results.
The intervention variable (defined as xt in the text) is measured in millions
of dollars in these tables. This approach allows the estimated coefficient
to determine the denominator of the portfolio shares and is preferred, to
the extent one lacks faith in the reliability of measurements of aggregate
wealth.11 We disaggregate the intervention variable by including Fed and
Bundesbank intervention separately. The three separate sets of regressions,
therefore, include intervention measured as the sum of Bundesbank and Fed
intervention, intervention by the Bundesbank, and intervention by the Fed.
Table 16.4 presents the instrumental variable regressions of equation (1)
over the latter subperiod, October 1984 to December 1988. The coefficient
on intervention is generally statistically significant, regardless of how it is
measured. This result implies that intervention, even if sterilized, had an
effect. If mark and dollar assets were perfect substitutes, then the coefficient
should have been zero: changes in asset supplies would have no effect on
the risk premium.
In order to check that the results reported in table 16.4 are robust, we
reestimated equation (1), excluding outliers and the variance constraint. In
order to examine the influence of outliers on the results, we searched for
regression residuals from equation (1) that were greater than 2.5 times the
standard error of the regression estimate. Over the full sample period, two
observations met the criterion: September 25,1985 (the second trading day
after the Plaza Accord) and March 5, 1986. Table 16.5 presents regression
estimates of equation (1) excluding the two outlying observations over the
latter subperiod and including the intervention variable as a percent of
wealth, rather than in millions of dollars. If we control for the definition of
intervention in the regression, the intervention coefficient estimates exclud
ing the two outliers are virtually identical to those reported in table 16.4.
The coefficient estimates on the variance terms, however, are no longer
statistically significant except when intervention is cumulated from the
beginning of the sample period. In a second set of tests presented in
table 16.6 we examine the sensitivity of the reported results to the meanvariance specification by reestimating (1) without constraining the variance
and intervention to enter multiplicatively. The estimated coefficients on
the intervention variables are qualitatively identical (in terms of statistical
significance) to those reported in tables 16.4 and 16.5.

Foreign Exchange Intervention

337

Table 16.3
Sample: November 1982-O cto b er 1984

- >lk +

+ M,.»

= Po + P,V,+

Biweekly three-month-ahead risk premium equation (Obs = 55, k = 90, j = 14, interven
tion expressed in millions of $) instruments: s,_;, sf^j k, ANNOCt, REPINTt
One-day*

Two-weekb

Cumulative0

11, includes Fed and Bundesbank intervention
(0.004)*

0.009

— 28.032

0.279

(0.706)

0.625

(0.197)**

(57.433)

0.009
- 3 8 .2 1 2

(0.004)*

0.005

(0.003)t

(60.749)

372.170

0.012

(0.061)

0.043

(0.009)**

0.621

(0.204)**

0.266

(0.369)

D.W.

2.16

2.15

1.94

0.41

0.39

(109.322)**

II If includes only Bundesbank intervention
(0.004)*

0.009

(0.004)*

0.005

0.009

- 5 5 .2 2 0

(63.241)

- 0 .7 8 4

(1.593)

0.003

(0.066)

0.045

(0.009)**

(0.189)**

0.632

(0.198)**

0.251

(0.411)

0.644

- 3 7 .3 1 9

(61.343)

371.305

D.W.

2.15

2.16

1.94

0.41

0.42

0.40

(0.003)t
(107.605)**

III I, includes only Fed intervention
(0.004)*

0.006

(0.004)

0.009

-2 7 .2 6 4

(55.588)

- 4 5 .1 9 3

(48.008)

369.001

(168.774)*

1.029

(1.762)

-0 .4 9 7

(0.647)

0.937

(0.365)*

0.615

(0.191)**

0.544

(0.362)

D.W.

2.17

2.16

2.06

0.41

0.39

0.31

(0.004)*

(0.203)**

0.009

0.645

a. Intervention variable is measured at the end-of-day prior to the survey.
b. Intervention variable is an accumulated measure between survey forecasts.
c. Intervention variable is an accumulated measure from the beginning of the sample
period.
Note: Standard errors are in parentheses, t denotes significance at the 90% level;
** denotes significance at the 99% level, p is the estimated first lag correlation coefficient.

Exchange Rate Expectations

338

Table 16.4
Sample: October 1984-D ecem ber 1988

i,T - i*» + As,% = p0 + M + Piv.l, + «..»
Weekly one-month-ahead risk premium equation (Obs = 185, k = 30, j = 7, intervention
expressed in millions of $) instruments: st j ,
ANNOCt, REPINTt
One-weekb

One-day*

Cumulative0

11, includes Fed and Bundesbank intervention
(0.001)

0.002

0.001

(0.001)

/},

53.851

(17.355)**

0.308

0.307

D.W.

2.12

2.13

2.22

0.08

0.14

0.11

0.002
39.501

(0.128)*

0.067

(0.194)

0.344

(0.002)

(13 . 7 6 6 r

217.216

(104.010)*

(0.030)*

0.009

(0.005)f

(0.202)f

0.449

(0.173)**

II I, includes only Bundesbank intervention
P„

0.002

(0.001)

0.002

(13.103)*

178.043

/?,

38.803

0.328

0.343

D.W.

2.15

2.18

0.13

0.15

0.16

(14.283)**

32.562

(0.001)t

(0.184)f

0.083

(0.176)f

0.347

(0.002)
(94.692)f

(0.053)

0.008

(0.005)

(0.191)t

0.397

(0.068)**

III I, includes only Fed intervention
0.002

(0.002)

0.001

(0.002)

0.002

(0.001)

49.716

(17.780)**

39.809

(14.076)**

64.535

0.410

(0.222)f

0.103

(0.055)f

0.018

(0.008)*

0.335

(0.176)f

0.361

(0.190)f

0.483

(0.177)**

D.W.

2.14

2.15

2.25

0.09

0.14

0.05

(20.422)**

Foreign Exchange Intervention

339

Table 1 6 .5
Sample: October 1984-Decem ber 1988
(omitting outlying observations on 9 /2 5 /8 5 and 3 /5 /8 6 )

i£k - h$k + A*?.* = A) + Pivt + PivJt +
Weekly one-month-ahead risk premium equation (Obs = 183, k = 30, j = 7, intervention
expressed as prcent of wealth) instruments: st. jf s?-jtk, ANNOC,, REPINT,
One-day*

One-weekb

Cumulative'

I If includes Fed and Bundesbank intervention
p0

0.003

19.728

7222.415

0.386

D.W.

2.20

2.17

2.23

0.19

0.20

0.19

(0.001)*
(14.734)
(2229.645)**
(0.177)*

0.003
18.039
1565.290
0.393

(0.001)*

0.003

(0.002)t

(14.675)

217.351

(71.927)**

(552.027)**

193.954

(67.694)**

(0.197)*

0.478

(0.198)*

II If includes only Bundesbank intervention
p0

0.004

16.721

6867.251

(2882.011)*

0.402

(0.165)*

D.W.

2.22

2.18

0.20

0.19

0.21

(0.002)*
(14.690)

0.004

(0.001)*

0.003

(0.001)*

(14.682)

450.834

(114.997)**

1926.778

(915.987)*

459.885

(120.435)**

0.389

(0.188)*

0.429

16.744

(0.362)

III Ir includes only Fed intervention
(0.002)t

0.003

(0.001)*

0.003

(0.002)

51.374

(22.239)*
(165.706)*

0.003

19.598

11792.140

0 .409

D.W.

2.21

2.20

2.28

0.18

0.20

0.13

(14.952)
(4571.997)**
(0.162)*

17.108

(14.694)

2557.322

(1059.437)*

372.542

0.422

(0.180)*

0.533

(0.172)**

a. Intervention variable is measured at the end-of-day prior to the survey.
b. Intervention variable is an accumulated measure between survey forecasts.
c. Intervention variable is an accumulated measure from the beginning of the sample
period.
Note: Standard errors are in parentheses, t denotes significance at the 90% level;
* denotes significance at the 95% level; ** denotes significance at the 99% level. The
coefficient on vtIt ( f t) and its corresponding standard error are divided by 100 for
readability, p is the estimated first lag correlation coefficient.

Exchange Rate Expectations

340

Table 16.6
Sample: October 1984-Decem ber 1988

i£k ~ 'Ik

+ As** = ft, + PiVt + P2v,It + uuk

Weekly one-month-ahead unconstrained risk premium equation
(Obs = 185, k = 30, j = 7, intervention expressed as percent of wealth)
instruments: s,_; , sf-jtk, ANNOC,, REPINTt
One-weekb

One-daya

Cumulative'

11, includes Fed and Bundesbank intervention

Po
Pi
Pi

0 .002

(O.OODt

0.003

(0.001)*

0.017

(0.006)**

30.639

(12.448)*

28.803

(12.295)*

38.850

(13.519)**

(3.725)**

1.641

(0.574)**

(0.228)

0.459

(0.232)*

43.774

(12 . 6 3 i r

12.325

P
D.W.

0.319

(0.196)

0.288

2.14

2.12

2.24

0.15

0.16

0.10

II I, includes only Bundesbank intervention

Po
Pi
Pi

0.003

(0.001)t

0.003

(0.001)*

0.028

(0.007)**

28.118

(12.459)*

26.513

(12.289)*

38.876

(13.124)**

(6.028)**

2.876

(0.848)**

(0.208)

0.402

(0.387)

39.366

(15.466)*

16.161

P
D.W.

0.342

(0.176)f

0.299

2.16

2.12

2.19

0.16

0.13

III I, includes only Fed intervention

Po
P.
Pi

(0.001)

0.002

(0.001)

0.004

(0.002)t

32.935

(12.714)**

30.822

(12.532)*

38.944

(14.106)**

82.379

(28.492)**

17.366

(6.612)**

3.679

(1.651)*

0.347

(0.179)f

0.334

(0.195)t

0.537

(0.192)**

0.002

P
D.W.

2.15

2.32

0.14

0.15

0.05

a. Intervention variable is measured at the end-of-day prior to the survey.
b. Intervention variable is an accumulated measure between survey forecasts.
c. Intervention variable is an accumulated measure from the beginning of the sample
period.
Note: Standard errors are in parentheses, t denotes significance at the 90% level;
* denotes significance at the 95% level; ** denotes significance at the 99% level.
p is the estimated first lag correlation coefficient.

Foreign Exchange Intervention

16.5

341

A Summary of the Quantitative Effects

Our two-equation system estimates indicate that official announcements
about exchange rate policy and reports of intervention influence exchange
rate expectations, and intervention operations influence the risk premium.
In this section, we make use of some of the parameter estimates from our
regression analyses as an example to calculate the effect of intervention on
the dollar/mark exchange rate. We assume in these calculations that inter
est rates in the United States and Germany are held constant. If interest
rates were allowed to vary, then the effects in a general portfolio-balance
model might be either smaller or larger than those reported here. Sterilized
intervention in support of the dollar, for example, might drive down dollar
interest rates, reducing the demand for dollar assets and thereby mitigating
the effect on the exchange rate.
First, consider the effect of intervention on the exchange rate if it is not
known publicly. We begin with the baseline case where expectations are
assumed to be neither extrapolative nor adaptive. Under these assump
tions, the intervention has no effect at all on the risk premium. If the risk
premium does not change, then equation (1) indicates that xt does not
change.
The portfolio share that is allocated to mark assets, xv is defined as
SfMf/Wt, where St is the spot mark-dollar exchange rate, M t is the total
quantity of mark assets in investors' portfolios (denominated in marks), and
Wt is total wealth (denominated in dollars). Analogously, the portfolio
share that is allocated to dollar assets, 1 — xt, is defined as Dt/W t where
Dt is the total quantity of dollar assets held in investors' portfolios and
StM t + Df = Wt. Sf, the spot exchange rate, is thus equal to:
$ =

M, 1 — x,

(3)

From this expression for Sf, it is evident that the effect of intervention on
the exchange rate is in proportion to the supply of mark assets in investors'
portfolios. What is the effect of 100 million dollars of intervention? If
we are thinking of the special case where only nonsterilized intervention
matters, then the definition of M t is relatively clear: total reserve money
supplied to the banking system by the Bundesbank, which, as of the end of
1988, was $124.19 billion.12 Thus the effect is only .081 percent. If we are
thinking of sterilized intervention, then the effect of 100 million dollars of
intervention will be even smaller, because M t is the total supply of mark-

Exchange Rate Expectations

342

denominated bonds, rather than just mark money. It should be emphasized
that these small magnitudes derive solely from the small size of interven
tion relative to the relevant denominators and not from any parameters
that we have estimated. But it is worth recalling that this effect even if
small, is nonetheless not zero, according to our rejection of perfect sub
stitutability between mark and dollar bonds.
To get large effects on the exchange rate, we need the public to hear the
news of the intervention. Our second experiment considers the effect of
such information in isolation, as reflected in the coefficient on the reported
intervention dummy variable, even if such intervention is in fact not taking
place. If intervention actually takes place and is publicly reported, then its
total effect would be the sum of the (small) effect reported in the preceding
paragraph plus the (much larger) effect reported in the next paragraph.
Under our baseline case (no change in interest rates and no extrapolative or
adaptive expectations), the risk premium simply changes by the coefficient
of REPlNTt in the expectation equation. Such a change in the risk premium
will have a large effect on the demand for mark-versus-dollar assets.
In order to calculate the effect of a report of intervention on the ex
change rate we need to return to equation (3). The log form of equation
(3) is:

log S, = log (J^ j + Iog(x,) - log(l -

Xt).

(4)

The derivative of the log of the spot exchange rate with respect to re
ported intervention can be calculated using (4) and the knowledge that xt
is a function of the risk premium, rpt, which in turn is a function of ex
pected depreciation, Asf%, which in turn is a function of the news variables
REPINTt and ANNOC,.
d log S,
dREPINT,

_| "l
U

~\dx,

drp,

1 ~ X ' W , dREPINT,'

The derivative of xt with respect to the risk premium is (vf/f2)-1 from
equation (1). If we rearrange equations (1) and (2), hold interest rates con
stant and set ol1 = 1 and a2 = 0, we see that the derivative of the risk
premium with respect to reported intervention is equal to the derivative of
the expected depreciation with respect to reported intervention, which is
a4 from equation (2). As an example, if we take x = .5 and take our parame
ter estimates from It defined as cumulative intervention, the effect of an

Foreign Exchange Intervention

343

intervention report on the exchange rate is 2.7 percent.13 If we measure xt
at the end of the sample period (.112),14 the effect is approximately twice
as large. If we take f}2 estimates from one-day or one-week intervention
equations, the effect is much smaller.
The expectations effect of news on the exchange rate seems high. One's
intuition that the effect should, in reality, be smaller can easily be fit into
any of several categories. First, it is possible, even if we are talking about
intervention that is sterilized in the sense that there is no change in the
money supply, that the interest rates will absorb some of the impact of
the decreased demand for mark assets (the German interest rate rising and
the U.S. interest rate falling), so that the depreciation of the mark will be
smaller. One would need to specify a complete portfolio-balance model to
answer how big the changes in the interest rates would be. But the effect
on the nominal interest differential need not be large to damp significantly
the reported effect on the spot rate.
Second, if one wishes to depart from the baseline case to consider the
possibility of extrapolative expectations, then the effects reported above
obtain only in the long-run equilibrium in which st — s,_x is zero. The
short-run impact effect could be smaller.15 For some readers an intuitively
appealing implication of extrapolative expectations is that, after the firstweek impact of the news, market forecasters react further to the observed
change in the exchange rate by jumping on the bandwagon, so that the
effect grows in subsequent weeks. Others may prefer to believe that expec
tations are regressive rather than extrapolative or that newspaper reports
or other random disturbances to the level of the spot rate, to the extent
that they are not confirmed subsequently by actual observed changes in
macroeconomic fundamentals, will gradually lose their effect on the spot
rate as time passes, and that this "unwinding factor" is not adequately
captured in our equations. This last possibility would constitute a third
factor that could reduce the effect on the spot rate in long-run equilibrium
below that reported above.16
Our own inclination is to believe that expectations only tend to be
extrapolative in occasional periods: speculative bubble environments, when
the foreign exchange market loses its moorings and forecasters forget about
fundamentals. O f course, these are precisely the periods in which central
bankers might be most interested in using the tool of intervention.17
The last circumstance in which the effect on the spot rate would be less
than that estimated here is if the event occurs during a period when the
variance is higher than it is on average. Again, this might be precisely the

344

Exchange Rate Expectations

sort of period in which central bankers would be most interested in using
intervention as a short-term tool, to smooth disorderly markets.18
Our results cannot be viewed as definitive. Nevertheless, to sum up, the
findings for the dollar/mark rate during our mid-1980s sample period are
generally favorable for the effectiveness of intervention. There appear to be
statistically significant effects both through the expectations channel and
through the portfolio channel. The quantitative effects can vary, depending
both on the particular estimates chosen for the key parameters and on
the precise experiment that one wishes to consider. But we hope that
the statistical significance of the effects that we find will contribute to
a reevaluation of the conventional wisdom as to the ineffectiveness of
intervention.

Appendix 16A:

Variable Definitions and Data Sources

log of the $/DM spot exchange rate at time t (source: DRI)
t, k

log of Money Market Services median fc-period-ahead expecta
tion for the $/DM rate at time t (source: MMS)
daily variance of $/DM exchange rate changes over the pre
ceding week

;DM
l t ,k

Euro-DM fc-period-ahead interest rate at time t (source: DRI)

Euro-$ fc-period-ahead interest rate at time t (source: DRI)

central bank intervention, in millions of $, known at time t19
(sources: Fed and Bundesbank)

IDM t

central bank intervention, in millions of DM, known at time t

ANNOCt

+ 1 for official central bank announcements in support of the
dollar since the last M M S survey date (source: newspapers20)
— 1 for official central bank announcements against the dollar
since the last MMS survey date (source: newspapers)
0 for no relevant central bank announcements (except interven
tion)

REPINT,

+ 1 for reported central bank intervention in support of the
dollar since the last MMS survey date (source: newspapers)
— 1 for reported central bank intervention against the dollar
since the last MMS survey date (source: newspapers)
0 for no reports of central bank intervention

SECINTt

+ 1 if /, > 0 and REPINTt = 0
- 1 if lt < 0 and REPINTt = 0
0 otherwise

Foreign Exchange Intervention

345

Acknowledgment
This chapter is one of several joint papers to follow from our first work on
this subject which was NBER Working Paper No. 3299. Another is forth
coming in the American Economic Review. Frankel would like to thank the
Center for International and Development Economics Research (funded at
U.C. Berkeley by the Ford Foundation) for support.

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