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June 10, 1983

u. S. Intervention Policy
Should the United States intervene more
often in foreign exchange markets to calm
market volati lity or even to change the value
of the dollar against other currencies? Or
should the U.5. maintain its present stance
of intervening only when exchange markets
are clearly "disorderly?"
U.5. intervention policy continues to be
debated in international forums and, most
recently, was an important topic of discussion at the economic summit in Williamsburg over Memorial Day weekend. The
leaders of several countries, most notably
France, believe that foreign exchange
markets, left to their own, are prone to
excessive short-term volatility and exchange
rate levels not justified by fundamental
economic factors (e.g., prices, income
levels, productivity gains). They see increased U.S. intervention relieving these
problems and lending stabilitytotheforeign
exchange market.

Present strategy
The United Statespresently follows an intervention strategy designed to "counter disorderly markets" when the need arises. This
goal is spelled out explicitly under Article I V
of the International Monetary Fund articles
of agreement and was emphasized as a
common point of agreement among the
economic summit participants at last year's
meeting in Versailles, France.
Under this strategy, U.5. authorities intervene in foreign exchange markets only
during periods of extreme market uncertainty. Such periods may be indicated by
rumors of war or major political change, or
by the partial or full withdrawal of private
institutional participants from the market.
Since early 1 981 , the U.S. Treasury and
Federal Reserve System have intervened
onlya few times, including once on the day
of the attempted assassination of President
Reagan (March 30, 1981) and once on
the day following a major cwrency realign-

ment of the European Monetary System
(june 14, 1982).
What is at issue now, however, is whether
the U.S. should increase the size and frequency of its intervention operations, and
join Europe and Japan in a coordinated effort
to influence currency values in a more .
systematic fashion.

Goals of intervention
Among the various arguments put forth
in support of increased U.S. intervention
operations, two general policy goals may be
identified. The first is to moderate short-term
fluctuations in exchange rates and, in
general, to calm the volatility in exchange
markets. As Chart 1 illustrates, these
week-to-week fluctuations have been large
and erratic in recent years. Proponents of
this view believe that the volatility in
. exchange markets disrupts international
trade and capital flows because it increases
exchange rate risk and thereby reduces the
willingness of firms and investors to engage
in international transactions. By smoothing
short-term transitory fluctuations, they
argue, official intervention might reduce the
risk associated with exchange rate volatility
and help ensure that exchange rate movements reflect underlying economic factors.
The presumption in this view is that foreign
exchange rates reflect "reasonable" or
equilibrium values along a trend, but that
fluctuations around the trend are caused by
transitory factors and should be reduced.
The intervention strategy often suggestedto
counter short-term volatility in exchange
markets is commonly called "leaning
against the wind." Under this strategy, the
authorities sell foreign currency when it
increases in value and purchase foreign
currency as it declines in value. The aim is
to slow, but not reverse, exchange rate
movements in an attempt to reduce overall
volatility. The exchange market setsthe
trend of the exchange rate path and the

lB@\fffilk\ C\J)
II

I f if
Opinions

expressed ill this newsletter do not
f'(:-fled the vipws of the management
of the Federal Reservl.' Bank of San francisco,
or of the Board of Covernors of the' Federal
Reserve System.
necessarilv

(In 1980, the percentage of total CN P consisting of exports was 29 percent in West
Germany, 21 percent in France, and 28 percent in Italy; it was only 10 percent
in the U.s.)

. authorities attempt to reduce fluctuations
around the trend.
The second policy goal is to maintain
currency values within certain "reasonable" values (e.g., as determined by their
relative purchasing power), often called
a "target zone:' Proponents of this view
bel ieve that exchange rate targeting is
necessary in order to avoid the large
medium-term swings in exchange rates that
the international economy has experienced
in recent years. They argue that large
medium-term swings in exchange rates
disrupt the international economy generally
and are particularly damaging to small,
export-oriented economies.

The "target zone" intervention strategy
suggests that central banks should purchase
foreign currency when it depreciates below
the lower bound of the target zone, and sell
foreign currency when it moves above the
upper bound. Such a strategy differs from a
system offixed exchange rate parities in that
it allows the authorities to shift the target
zone in response to changes in fundamental
economic conditions.
The target zone strategy thus presumes that
the authorities are better able to determine
equilibrium exchange rate values than the
market mechanism. Not only does the strategy call for countering the fluctuations
around a given trend, as in the "leaning
against the wind" strategy, it also calls for
determining the trend of exchange rates.

To the extent that exchange rate swings
diverge from inflation differentials across
countries, the competitive position of a
country compared to its trading partners will
change. As Chart 2 demonstrates, these
"real" exchange rate swings have been
substantial for the u.s. ollar. From a low
d
in May 1974, for instance, the real rate appreciated more than 12 percent over the
following two years, only to switch course
and depreciate 10 percent during the period
1977-78. The dollar began an upward
swing in late 1980 and appreciated over
20 percent by the end of 1982.

tion. The more /lopen" a country in terms of

Effectivenessof intervention
The modern theory of exchange rate determination suggeststhat intervention is
probably effective in moderating exchange
rate fluctuations on a daily or weekly basis,
but that it doesn't have much effect over
longer periods unless countries also adjust
their domestic policies to bring about an
"external" balance. The limited empirical
evidence that is available seems to support
this view. A major international study on
official intervention commissioned after last
year's economic summit in Versailles, for
example, concluded that "intervention can
be useful to counter disorderly markets and
to reduce volatility" but "will normally
be useful only when complementing and
supporting other policies:'

the share of CN P accounted for by exports,
the larger the disruptive impact these real
exchange rate swings may have on the
economy. European concerns regarding
exchange rate swings may be traced, at least
in part, to their export-oriented economies.

Modern exchange rate theory distinguishes
three basic channels through which official
intervention works: the "flow supplydemand" channel, the "portfolio balance"
channel and the "signalling" channel. The

These swings disrupt production and consumption decisions by shifting relative
prices between exports and imports (and
import-competing goods), and lead to large
changes in the use of a country's resources.
The costs to an economy of making these
changes can often be substantial. Workers,
for example, haveto be retrained to produce
the new output "mix:' They may suffer
bouts of unemployment during the transi-

2

Chari 2

CharI 1

Real Effective Dollar Exchange Rate

Short·Term Volalllily of Trade·Welghted Dollar
'915 = 1 M

P!.'(cenlchange

125

4

-3

Implications

first refers to the immediate impact a purchase or sale of foreign currency by a central
bank has on the exchange rate, as it changes
the flow supply 0 r dema nd for th at currency.
When the authorities buy foreign currency,
for instance, they increase the flow demand
forforeign currency and the currency will
have a tendency to rise in value. Once the
bank withdraws from exchange operations,
however, flow demand is reduced and the
currency may return to its original value.

Both theory and empirical evidence suggest
that official intervention may be effective
when directed toward reducing short-term
exchange rate fluctuations, but not longerrange values unless they are accompanied
by fundamental policy changes. This is a
serious shortcoming because medium-term
(for example, over one year) swings in exchange rates probably have a much greater
adverse economic effect than short-term·
volatility. Moreover, firms and consumers
affected by exchange rate variations can
protect themselves against short-term
exchange rate uncertainty by hedging their
positions through the forward exchange
market. This hedging involves costs but the
evidence suggests they are not large,

Intervention may also influence exchange
rates through a portfolio balance effect. To
support the domest ic cu rrency, for exam pie,
a central bank may purchase domestic
securities and pay for the acquisition by
disposing of foreign securities.* From the
private sector's point of view, it has fewer
domestic securities in its portfolio, and more
foreign currency securities. Investors may
not be indifferent about the mix of securities
in their portfol ios. If not, they will try to
restore their portfolios by buying domestic
securities and selling foreign securities. This
shift of demand toward domestic securities
at the expense of foreign securities means
a capital inflow to the country, placing
upward pressure on the domestic currency
and causing it to appreciate. The empirical
evidence suggests,however, that this effect
is either small or variable in magnitude, and
hence difficult to measure. This is not surprising as stocks of securities privately held
are so large that limited intervention operations wi II only slightly change the composition of portfolios.

It is much moredifficultto hedge against the
risks associated with medium-term movements that reflect "real" exchange rate
changes and shifts in international competitive advantage. Firms engaged in international trade, for instance, often complain
aboutthe difficulties posed by these competitive shifts in making production and marketing decisions. [n sum, undue emphasis
appears to have been placed on short-term
exchange rate volatility and risk when
medium-term fluctuations probably impose
greater real costs on society.
The industrial countries face a difficu It
choice. On the one hand, central bank intervention seems most effective in curbing
short-term volatility, butthis effectiveness
has little utility because hedging allows
private traders to protect themselves against
all except the most extreme short-run fluctuations. On the other hand, intervention
operations pursued independently of other
policy changes have little effect on the
medium-term fluctuations that are potentially most damaging to economies.
Concern for the latter problem argues that
the industrial countries should focus on
coordinating their divergent macroeconomic policies.

Finally, intervention may affect exchange
rates if market participants believe that it
signals a fundamental change in policy that
would alter the future path of exchange
rates.This effect, however, lasts only as long
as market participants continue to believe
that the "signal" is true, that is, that fundamental macroeconomic policies are
changed to bring about external adjustment.
*This analysisassumes
that the centralbank makesan
offsetting open-marketpurchaseof domestic securitiesto
prevent the intervention from having monetaryeffects.

MichaelHutchison
3

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BANKING DATA-TWELFTHFEDERAL
RESERVE
DISTRICT
(Dollar'amounts millions)
in
Selected
AssetS Liabilities
and
LargeCommercialBanks
Loans(gross,
adjusted) investments*
and
loans (gross,
adjusted) total#
Commercialand industrial
Realestate
loans to individuals
Securities
loans
U.S.Treasury
securities*
Other securities"'
Demanddeposits- total#
Demanddeposits adjusted
Savings
deposits- totaH
Time deposits-total#
Individuals,part & corp.
(Large
negotiable
CD's)
WeeklyAverages
of Daily Figures
Member BankReserve
Position
Excess
Reserves )/Deficiency(-)
(+
Borrowings
Net free reserves+ )/Net borrowed(
(
-)

Amount
Outstanding

Change
from

5/25/83
161,997
140,406
44,264
56,176
23,550
2,697
7,918
13,673
39,241
28,138
66,476
64,854
58,439
18,808

5/18/83
- 677
- 539
- 115
29
27
- 190
- 80
- 58
-1,105
86
173
- 481
- 207
- 247

Change
from
yearago
Dollar
Pecent
r
2,660
1,830
599
- 958
258
844
1,740
- 910
2,017
1,945
36,028
- 30,317
- 26,866
- 16,745

Weekended

Weekended

5/25/83

5/18/83

106

101
6
95

59
47

-

-

-

1.7
1:3
1.4
1.7
1.1
45.5
28.2
6.2
5.4
7.4
118.3
31.9
31.5
47.1

Comparable
period
97
23
74

* Excludes
tradingaccountsecurities.
# Includesitemsnot shownseparately.
t IncludesMoneyMarketDeposit
Accounts,
Super-NOW
accounts, NOW accounts.
and
Editorialcomments
maybeaddressed theeditor (Gregory
to
Tong) to theauthor•••• Free
or
copies
of
this and other Federal
Reserve
publications beobtainedby callingor writing the PublicInformacan
tion Section,Federal,Reserve of SanFrancisco, Box7702,SanFrancisco
Bank
P.O.
94120.Phone
(415)
974·2246.