Bulls, bears and excess volatility: can currency intervention help?

Asset mis-pricing may reflect investor psychology; and excess volatility can arise from switches of sentiment. For a floating exchange rate where fundamentals follow a random walk, we show that excess volatility can be generated by the repeated entry and exit of currency 'bulls' and 'bears' with switches driven by 'draw-down' trading rules. We argue that non-sterilized intervention-in support of 'monitoring band'-can reduce excess volatility by coordinating beliefs in line with policy. Strategic complementarity in the foreign exchange market suggests that sterilized intervention may also play a coordinating role. Copyright © 2007 John Wiley & Sons, Ltd.