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The Political Economy Of Foreign Exchange Market Intervention

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  • Shinji Takagi

    ()
    (Graduate School of Economics, Osaka University)

  • Kenichi Hirose

    ()
    (Otaru University of Commerce)

  • Issei Kozuru

    ()
    (Kosei Securities Testing the Effectiveness of Market-B)

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    Abstract

    The paper tests the effectiveness of marginal reserve requirements employed by the Japanese authorities in the 1970s to influence short-term capital flows, thereby contributing to the ongoing debate on the use of capital controls\market- or price-based ones in particular. While the case for using market-based controls almost entirely relies on the mixed evidence from the experience of Chile with unremunerated reserve requirements in the 1990s, testing for their effectiveness on the volume of inflows is hampered by the endogeneity of such a measure, which is typically imposed or intensified when inflows surge. We address this problem by applying the method of propensity score matching and find that an increase in marginal reserve requirements modestly reduced the volume of short-term capital inflows through non-resident free-yen accounts. The impact was not statistically significant, however, implying that the price elasticity of short-term capital flows was small. We conclude that market-based controls must be nearly prohibitive, perhaps combined with administrative measures, to be effective in a meaningful way.The paper presents a political economy model of official foreign exchange market intervention and tests the model against the recent experience of Japan. In several industrial countries, the government is responsible for intervention decisions while the central bank is given operational independence in its conduct of monetary policy. The paper models the interaction between the two agencies, empirically tests the central bank reaction function, and considers conditions under which intervention might change monetary policy. Daily Japanese intervention data give broad support to the prediction of the model with respect to central bank behavior. Although it is difficult to be definitive about the hidden motive of central bank actions, during the extraordinary period of 2001-04 when Japan remained under deflationary pressure, the central bank, faced with large political costs of sterilization, accommodated a considerable portion of the massive interventions made by the government. Under normal conditions coordination between the two agencies might be desirable, not least to make the signal of any intervention credible, but giving an alternative agency the authority over intervention decisions can be a means of enhancing democratic accountability for an independent central bank while preserving the credibility of monetary policy.

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    File URL: http://www2.econ.osaka-u.ac.jp/library/global/dp/1204.pdf
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    Bibliographic Info

    Paper provided by Osaka University, Graduate School of Economics and Osaka School of International Public Policy (OSIPP) in its series Discussion Papers in Economics and Business with number 12-04.

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    Length: 48 pages
    Date of creation: Apr 2012
    Date of revision:
    Handle: RePEc:osk:wpaper:1204

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    Web page: http://www.econ.osaka-u.ac.jp/
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    Keywords: foreign exchange market intervention; central banking; quantitative easing; Japanese intervention;

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    1. Nobuyuki Oda & Kazuo Ueda, 2005. "The Effects of the Bank of Japan's Zero Interest Rate Commitment and Quantitative Monetary Easing on the Yield Curve: A Macro-Finance Approach," CIRJE F-Series, CIRJE, Faculty of Economics, University of Tokyo CIRJE-F-336, CIRJE, Faculty of Economics, University of Tokyo.
    2. Holub, Tomáš, 2004. "Foreign exchange interventions under inflation targeting: the Czech Experience," Research Notes 17, Deutsche Bank Research.
    3. Rasmus Fatum & Michael M. Hutchison, 2005. "Foreign Exchange Intervention and Monetary Policy in Japan, 2003-2004," Hi-Stat Discussion Paper Series, Institute of Economic Research, Hitotsubashi University d05-93, Institute of Economic Research, Hitotsubashi University.
    4. Jung, Taehun & Teranishi, Yuki & Watanabe, Tsutomu, 2005. "Optimal Monetary Policy at the Zero-Interest-Rate Bound," Journal of Money, Credit and Banking, Blackwell Publishing, Blackwell Publishing, vol. 37(5), pages 813-35, October.
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