Exchange Rate Volatility, Foreign Exchange Market Intervention and Asymmetric Preferences

Abstract

Article History KeywordsAsymmetric preferences Foreign exchange market Intervention Emerging markets Exchange rate volatility Optimal reaction function GMM. JEL Classification:E58; E61; F31; G15.Policymakers in emerging market economies intervene in currency markets to counter appreciation or depreciation pressure, while also responding to the degree of exchange rate volatility. This paper investigates whether the asymmetric response in terms of foreign exchange intervention depends on the degree of exchange rate volatility. Specifically, we estimate whether the response by policymakers to currency market conditions differs in above or below threshold levels of volatility. We use dynamic threshold panel analysis presented within an asymmetric policy reaction function to investigate the role of exchange rate volatility in foreign exchange intervention. We estimate the model using Generalized Method of Moments (GMM) with monthly data for 23 emerging market economies from 2000 to 2016. We find that the asymmetric aversion to appreciation only holds under below-threshold volatility scenarios, and that the majority of the time, policymakers are simply leaning against exchange rate movements to ensure stable exchange rate conditions. The results confirm that exchange rate volatility impacts the response of policymakers to exchange rate conditions. Contribution/Originality: This study assesses how exchange rate volatility impacts foreign exchange policy decisions in emerging and developing economies. We provide evidence that prior literature, which did not consider volatility, missed an important policy concern for central banks in these economies when analyzing the existence of asymmetric preference in foreign exchange intervention.

Sources of real exchange rate fluctuations in Egypt

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Foreign Exchange Pressure and Foreign Exchange Intervention in Nigeria: A Review of Literature

“…Gusmanita et al [31] utilized panel data analysis and found that credit within the domestic economy had a notably adverse influence on the EMP, indicating how the expansion of domestic credit affects the increase in net capital flows. Keefe & Shadmani [32] used dynamic threshold panel methodology and Generalized Method of Moments (GMM) and findings revealed that the non-linear aversion towards appreciation holds only in scenarios below-threshold volatility. The outcome revealed that volatilities in the exchange rate influenced the degree of response from policymakers to exchange rate dynamics.…”