A market microstructure analysis of foreign exchange intervention

We formulate a market microstructure model of exchange determination we employ to investigate the impact of foreign exchange intervention on exchange rates and on foreign exchange (FX) market conditions. With our formulation we show i) how foreign exchange intervention influences exchange rates via both a portfolio-balance and a signalling channel and ii) derive a series of testable implications which are coherent with a large body of empirical research. Our investigation also proposes some normative recommendations, as we show i) that in extreme circumstances large scale foreign exchange intervention can have destabilizing effects for the functioning of FX markets and ii) that the route chosen for the implementation of official intervention has important implications for its impact on exchange rates and on market conditions. JEL Classification: D82, G14, G15