More than words: Foreign exchange intervention under imperfect credibility

Central banks in emerging countries frequently build‐up (diminish) reserves while attempting to depreciate (appreciate) their currencies. Even if these interventions are effective, they often entail various costs. Basu (2012), nonetheless, proposes a model in which the sole announcement of an intervention schedule leads to a desired exchange rate without actually buying or selling foreign currency. In this paper, we present a generalization that allows for imperfect credibility of promises. Namely, market dealers know that the central bank carries strategic incentives when announcing its schedule and may not perfectly believe it. We show that, under this setup, it may be impossible to achieve the targeted rate without changing the level of international reserves. However, committing to a schedule, despite being imperfectly credible, outperforms unannounced discretionary interventions. This is the case because it reduces the amount of foreign currency trading required for a central bank to meet its desired exchange rate.