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Solving Endogeneity in Assessing the Efficacy of Foreign Exchange Market Interventions

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  • Seok Gil Park

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    (Indiana University)

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    Abstract

    Sterilized foreign exchange market interventions have been suspected of being inefficient by many empirical studies, but they are plagued by endogeneity problems. To solve the problems, this paper identifies a system that depicts interactions between the interventions and the foreign exchange rate. The model shows that the interventions are effective when the interventions alter the market participants' conditional expectations of the rate without decreasing the conditional variances. This paper estimates Markov-switching type policy reaction functions by conditional MLE, and market demand/supply curves by IV estimation with generated regressors. The empirical results verify that the interventions of the Bank of Korea from 2001 to 2002 were indeed effective.

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    File URL: http://www.iub.edu/~caepr/RePEc/PDF/2007/CAEPR2007-004.pdf
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    Bibliographic Info

    Paper provided by Center for Applied Economics and Policy Research, Economics Department, Indiana University Bloomington in its series Caepr Working Papers with number 2007-004.

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    Length: 23 pages
    Date of creation: Feb 2007
    Date of revision:
    Handle: RePEc:inu:caeprp:2007004

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    Keywords: Sterilized intervention; Endogeneity; Markov-switching policy function;

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    1. Bonser-Neal, Catherine & Tanner, Glenn, 1996. "Central bank intervention and the volatility of foreign exchange rates: evidence from the options market," Journal of International Money and Finance, Elsevier, vol. 15(6), pages 853-878, December.
    2. Kathryn M. Dominguez, 1993. "Does Central Bank Intervention Increase the Volatility of Foreign Exchange Rates?," NBER Working Papers 4532, National Bureau of Economic Research, Inc.
    3. Richard K. Lyons, 2006. "The Microstructure Approach to Exchange Rates," MIT Press Books, The MIT Press, edition 1, volume 1, number 026262205x.
    4. Kearns, Jonathan & Rigobon, Roberto, 2005. "Identifying the efficacy of central bank interventions: evidence from Australia and Japan," Journal of International Economics, Elsevier, vol. 66(1), pages 31-48, May.
    5. Mark P. Taylor, 1995. "The Economics of Exchange Rates," Journal of Economic Literature, American Economic Association, vol. 33(1), pages 13-47, March.
    6. Christopher J. Neely, 2005. "An analysis of recent studies of the effect of foreign exchange intervention," Working Papers 2005-030, Federal Reserve Bank of St. Louis.
    7. Dominguez, Kathryn M., 1998. "Central bank intervention and exchange rate volatility1," Journal of International Money and Finance, Elsevier, vol. 17(1), pages 161-190, February.
    8. Meese, Richard A. & Rogoff, Kenneth, 1983. "Empirical exchange rate models of the seventies : Do they fit out of sample?," Journal of International Economics, Elsevier, vol. 14(1-2), pages 3-24, February.
    9. Galati, Gabriele & Melick, William & Micu, Marian, 2005. "Foreign exchange market intervention and expectations: The yen/dollar exchange rate," Journal of International Money and Finance, Elsevier, vol. 24(6), pages 982-1011, October.
    10. Gwang-Ju Rhee & Eun Mo Lee, 2005. "Foreign exchange intervention and foreign exchange market development in Korea," BIS Papers chapters, in: Bank for International Settlements (ed.), Foreign exchange market intervention in emerging markets: motives, techniques and implications, volume 24, pages 196-208 Bank for International Settlements.
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