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This paper examines the effectiveness of foreign exchange intervention in a two-country, two-currency, general equilibrium model that allows for liquidity effects. Both sterilized and non-sterilized intervention operations have significant impacts on the allocation of liquidity in international financial markets. Whether intervention is successful in moving the exchange rate in the desirable direction depends upon the degree of sterilization of intervention and the intratemporal elasticity of substitution of the consumption goods. The model shows that there exist circumstances in which the response of exchange rate to intervention is ‘perverse’ as documented in the empirical literature.

In order to affect the exchange rates, monetary authorities intervene in foreign exchange markets by buying or selling foreign exchange, normally against their own currency. There are two types of interventions: non-sterilized intervention and sterilized intervention. Non-sterilized intervention affects the supply of domestic currency in the foreign exchange market, and results in a change in the domestic monetary base. Its effect on the nominal exchange rate is therefore analogous to that of a change in domestic monetary policy. Sterilized intervention neutralizes the effect of foreign exchange intervention on the domestic monetary base by an offsetting open market operation of domestic-currency-denominated bonds, and causes only a ‘pure’ change in the currency denomination of assets held by the public. Hence, sterilized intervention is independent of monetary policy, and if it is an effective instrument for exchange rate management, monetary authorities can maintain greater flexibility of their monetary policy. Because of this reason, there has been a large research effort on the effectiveness of sterilized intervention in theory and practice. In the literature, sterilized intervention has been viewed as having effects on exchange rates through either of two channels: the portfolio-balance channel and the signaling channel.1 However, the evidence on the effectiveness of intervention via the two channels is inconclusive. Given the data showing that interventions in the markets for major currencies have been substantial and frequent in recent years, there is a clear need to provide a satisfactory explanation of why central banks engage in foreign exchange interventions to such a large extent. As both sterilized and non-sterilized intervention operations result in changes in asset supplies, such changes can have significant impact on liquidity in international financial markets. When economic agents are subject to liquidity constraints, liquidity effects induced by official intervention should be taken into account. The analyses of the effectiveness of intervention via the portfolio-balance channel and the signaling channel have ignored the crucial function of international financial markets in allocating liquidity across market participants. Hence, it will be beneficial to investigate theoretically the impacts of intervention within the context of a two-country, two-currency, general equilibrium model that allows for liquidity effects. Recent work on liquidity effects of monetary policy shocks in closed economy settings by Bernanke and Blinder (1992), Christiano and Eichenbaum (1995), and Strongin (1995) have provided strong empirical support for liquidity effects.2Eichenbaum and Evans (1995), and Grilli and Roubini (1995) extend this line of research to open-economy settings and find that expansionary shocks to US monetary policy are followed by sharp declines in US interest rates and sharp depreciations in US nominal and real exchange rates.3 These findings are consistent with the predictions of the open-economy models allowing for liquidity effects studied by Grilli and Roubini (1992), Ho (1993), and Schlagenhauf and Wrase, 1995a and Schlagenhauf and Wrase, 1995b. By following Lucas (1990)’s approach to modeling an asymmetry of monetary injections, these theoretical models examine the liquidity effects of monetary shocks on the world economy.4 As economic agents are affected by the liquidity shocks asymmetrically, the redistribution of liquidity in international financial markets not only causes fluctuations in exchange rates and interest rates but also has real effects on the world economy. Given that intervention can affect the allocation of liquidity in international financial markets substantially, further research on the liquidity effects induced by intervention may provide new insight into a better understanding of the effectiveness of foreign exchange intervention. The purpose of this paper is to reexamine the effects of foreign exchange intervention in a two-country, two-currency, general equilibrium model that allows for liquidity effects. The world economy is a monetary economy in which money is introduced by imposing cash-in-advance constraints on all transactions. Economic agents of the two countries are linked together by trade in goods and financial assets. The limited participation assumption implies that different economic agents face different trading opportunities. Shocks to the world economy will induce a reallocation of liquidity across different types of market participants and therefore generate liquidity effects. The nominal exchange rate is determined by the demands and supplies of the two currencies in the foreign exchange market, which reflect both the liquidity of the foreign exchange market and the relative liquidity of the home-currency-denominated asset market and the foreign-currency-denominated asset market. This paper presents an alternative channel of influence of foreign exchange intervention that emphasizes the role of international financial markets in allocating liquidity. To make the analysis more transparent, assumptions are made to ensure that both the portfolio-balance channel and the signaling channel are absent in the model. When the domestic monetary authority conducts an official sale of domestic currency so as to keep the domestic currency from appreciating, the supply of domestic currency to the foreign exchange market increases. In order to clear the market, the nominal exchange rate rises, and the sellers (buyers) receive (pay) more home currency for each unit of foreign currency traded. In addition to this direct impact on the liquidity in the foreign exchange market, the relative liquidity of the two asset markets are affected by the resulting adjustments of the domestic monetary authority’s asset holding. In the case of non-sterilized intervention, the domestic monetary authority uses the proceeds of foreign currency from the official sale of domestic currency to purchase the foreign-currency-denominated bonds. This increase in the supply of liquidity causes a decrease in the interest rate on the foreign-currency-denominated assets and a reallocation of liquidity in this market. In the case of sterilized intervention, the domestic monetary authority not only purchases the foreign-currency-denominated bonds but also conducts an open market sale of the domestic-currency-denominated bonds to sterilize the effect of intervention on the domestic money supply. As the demand for liquidity in the home-currency-denominated asset market rises, the interest rate on these assets rises, and the allocation of liquidity changes. These liquidity shocks to the asset markets affect the economic activities of the market participants, which, in turn, generate downward forces on the nominal exchange rate. Hence, whether an intervention operation can move the exchange rate in the desirable direction depends upon the relative strength of all of these liquidity effects. The effects of foreign exchange intervention on exchange rate and interest rates can be summarized as follows. First, non-sterilized intervention is always effective in affecting an exchange rate as it is analogous to a change in monetary policy. However, the impact of a non-sterilized intervention operation and that of an open market operation on interest rates are different qualitatively. Although both non-sterilized intervention and monetary policy involve monetary injections to the economy, the injections are channeled through different markets. As the induced liquidity shocks occur in different markets, these two policies will have different impacts on the interest rates. Second, even though sterilized intervention is less effective than non-sterilized intervention, it can influence an exchange rate in the desirable direction when the consumption goods are substitutes in consumers’ preferences. This implies that sterilized intervention can be undertaken independently for exchange rate management, allowing monetary authorities to have greater flexibility of their monetary policy. Third, when intervention is sterilized and when the goods are not substitutes in consumption, the liquidity effect in the foreign exchange market will be dominated by the liquidity effects in the asset markets so that the equilibrium effect of sterilized intervention on the exchange rate will be insignificant or even in the wrong direction. This result is consistent with the empirical evidence that intervention either had no insignificant effect or moved the currency significantly in the wrong direction. Kaminsky and Lewis (1996) document that in 1987, dollar buying interventions led to a significant depreciation in the US dollar; and during 1988 and 1989, the official sales of the US dollar led to an appreciation in the dollar. Bhattacharya and Weller (1997) presented a theoretical explanation for these puzzling ‘perverse’ responses of exchange rates documented in the empirical literature on intervention by examining the signaling channel in an asymmetric information model that characterizes the strategic interactions between the central bank and speculators. In contrast, this paper stresses the allocative function of international financial markets and presents an alternative explanation for the empirical puzzle by using a two-country, two-currency, general equilibrium model with liquidity effects. The remainder of the paper is organized as follows. Section 2 describes the model. Section 3 presents a stationary equilibrium of the world economy. The effects of foreign exchange intervention on the world economy are discussed in Section 4. Section 5 concludes the paper.

This paper presents a two-country, two-currency, general equilibrium model to study the effectiveness of foreign exchange intervention by examining the liquidity effects generated by intervention. In the model, the influence of intervention on the exchange rate is through neither the portfolio-balance channel nor the signaling channel. By assuming the existence of a forward exchange market, the foreign exchange risk of holding an asset denominated in the currency of another country can be eliminated completely. As the (covered) effective rates of return on the domestic and foreign assets are equalized, economic agents are completely indifferent as to whether they hold the domestic or foreign assets. In addition, by assuming that intervention policy is independent of both the current and future monetary policy variables, intervention does not provide a signal of future monetary policy. Hence, neither the portfolio-balance channel nor the signaling channel are present in this model. In contrast, this paper emphasizes the role of international financial markets in allocating liquidity. Both sterilized and non-sterilized intervention operations have significant impacts on the allocation of liquidity in international financial markets. Whether intervention is successful in moving the exchange rate in the desirable direction depends upon the degree of sterilization of intervention and the intratemporal elasticity of substitution of consumption goods. As intervention not only affects asset prices but also influences real activity, it is obvious that the economic welfare of each country will be affected, implying the incentives for monetary authorities to behave strategically when conducting foreign exchange intervention. A complete investigation of the strategic interaction of the monetary authorities in a general equilibrium framework would be an interesting topic for future research.