Does Central Bank Intervention Reduce Exchange Rate Volatility? An Empirical Investigation Using Tanzanian Data

Many developing countries including Tanzania have often resorted to intervene in the foreign exchange market to contain the effect of temporary exchange rate shocks on inflation and financial stability. Highly variable exchange rates increase exchange rate risk and are likely to impede long term planning and investment. While these countries have implemented this policy, the overriding question in the literature is, have these interventions really reduced unwarranted short-run exchange rate volatility‘ Mean GARCH models are used to investigate the efficacy of foreign exchange market interventions in Tanzania using daily data for the period 1997 to 2005. It was found that the coefficient of intervention in the forecasted volatility equation is negative and significant, which implies that interventions reduce volatility. It is evident that the effectiveness of these interventions may be constrained by traders' speculative tendencies to bit the market predominantly against the central bank. Thus, as much as the monetary authority should continue its presence in the foreign exchange market, it should identify the sources of speculative currency trading and address them