Exchange rate volatility and optimal central bank intervention

This research re-examines the desirability of central bank interventions in foreign exchange to reduce spot exchange rate volatility. A small open-economy macroeconomic model is developed to incorporate both macroeconomic fundamentals and micro-structural features of foreign exchange markets. The research derives the optimal central bank intervention based on the fundamental exchange rate, the target exchange rate and the last-period exchange rate. Numerical simulations suggest that central bank interventions tend to dampen spot exchange rate volatility, regardless of the source of disturbances. However, in most cases, central bank interventions only have rather modest effects. Further, the desirability of central bank intervention is generally insensitive to the degrees of price flexibility, capital mobility, speculation, and central bank’s commitment to its target exchange rate.