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Interdependencies between Monetary Policy and Foreign Exchange Intervention under Inflation Targeting: The Case of Brazil and the Czech Republic

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  • Gnabo, Jean-Yves
  • de Mello, Luiz
  • Moccero, Diego

Abstract

The bulk of recent literature on foreign exchange interventions has overlooked the potential interdependencies that may exist between these operations and the conduct of monetary policy. This is the case even under inflation targeting and especially in emerging-market economies, because central banks often explicitly reserve the right to intervene to calm disorderly markets and to accumulate foreign reserves, and when the exchange rate is perceived as being out of step with fundamentals. This paper uses a friction model to estimate intervention reaction functions and the associated marginal effects for Brazil and the Czech Republic since the adoption of inflation targeting in these countries in 1999 and 1998, respectively. The main findings are that: (i) in both countries interventions occur predominantly to reduce exchange rate volatility, while in Brazil the central bank also reacts to exchange rate deviations from medium-term trends; (ii) there are strong, asymmetric threshold effects in the reaction functions, and interventions are more likely and of higher magnitudes when they are carried out to depreciate than to appreciate the domestic currency; and (iii) interventions seem to take place independently of contemporaneous monetary policy in Brazil, but not in the Czech Republic, where both policies appear to be interrelated.

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File URL: http://www.wider.unu.edu/stc/repec/pdfs/rp2008/rp2008-95.pdf
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Bibliographic Info

Paper provided by World Institute for Development Economic Research (UNU-WIDER) in its series Working Paper Series with number RP2008/95.

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Length: 28 pages
Date of creation: 2008
Date of revision:
Handle: RePEc:unu:wpaper:rp2008-95

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Keywords: monetary policy; interventions; inflation targeting; friction model; Brazil; Czech Republic;

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