DP5468 | A Market Microstructure Analysis of Foreign Exchange Intervention

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20/01/2006

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Abstract

We formulate a market microstructure model of exchange determination we employ to investigate the impact of foreign exchange intervention on exchange rates and on foreign exchange (FX) market conditions. With our formulation we show i) how foreign exchange intervention in°uences exchange rates via both a portfolio-balance and a signalling channel and ii) derive a series of testable implications which are coherent with a large body of empirical research. Our investigation also proposes some normative recommendations, as we show that central bank intervention can be destabilizing for the functioning of FX markets and that the route chosen for the implementation of o±cial intervention has important implications for its impact on exchange rates and on market conditions.