Money Market Interventions

Table of Contents

II. Table of Figures

1. Introduction

2. The mechanism of exchange market operations

3. Supporting the exchange rate
3.1 The ECB intervention in September 2000
3.2 Economic effects
- Balance of payments

4. Capping the Exchange rate
4.1 The FED intervention in 1985
4.2 Economic effects
- Balance of payments

5. Efficiency of interventions

6. Monetary impacts of interventions
6.1 Sterilisation of interventions

7. Conclusion

III. Appendix
III.a Endnotes
III.b Tables

IV. Table of Literature
IV.a References
IV.b Bibliography
IV.c Websites

II. Table of Figures

Diagram 1: Supporting the currency

Diagram 2: Capping the currency

Diagram 3: Intervention on 22nd September 2000 (adjusted)

Diagram 4: Intervention on 22nd September with real rates

Diagram 5: FED Interventions during 1977-2002

Diagram 6: Depreciation of US $ against German Marks during 1985 - 1990

Diagram 7: Development of the US trade deficit

Diagram 8: Development of US Exports

Diagram 9: Trend of the euro from 1999-2001

Diagram 10: Enlarged window of the pre- and post-intervention period

Diagram 11: Changes in foreign currency reserves

Diagram 12: Development of US $ Interest Rates

Diagram 13: Development of US broad money

Diagram 14: Reaction of the DAX on the Intervention

Diagram 15: Reaction of the US Stock markets

Table 1: Standard deviation from basic trend after the invention

1. Introduction

After the collapse of the Bretton-Woods-System in 1973 and the transition to a system of floating rates between the major global currencies, central banks still use interventions for exchange rate maintenance. This paper aims to examine the function of Central Bank operations in foreign exchange markets on the basis of two empirical data sets, explaining both, appreciation and depreciation. It tries to analyse the impacts on capital flows recorded in the balance of payments and the efficiency of interventions. Further it will analyse the impacts on domestic monetary supplies and if necessary how to sterilise these effects. At certain stages endnotes will refer to the appendix for more detailed explanations or data.

2. The mechanism of exchange market operations

To illustrate, how central bank interventions work, we will take the European Central Bank (ECB) as an example and concentrate on two currencies, the euro (€) and the US dollar ($).

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Diagram1: Supporting the currency Diagram 2: Capping the currency

Appreciation (see diagram 1)

If the ECB aims at an appreciation of the own currency, the bank will engage in a foreign exchange operation and buy euros against its US dollar reserves. The demand for euros increases (demand curve shifts to the right) and simultaneously supply is reduced, because the ECB takes Euro out of the market (supply curve shifts to the left). Through the forces of supply and demand the value of the euro will strengthen in international markets (the exchange rate moves from r₁ to r₂).

Depreciation (see diagram 2)

If the ECB aims at a depreciation of the own currency, the bank will sell euros against dollars. In this case, demand for euros declines (demand curve shifts to left) and the supply increases (shift to the right) because the ECB pays the purchased dollars in euro. Again, the forces of supply and demand determine the new exchange rate at r₂. The value of the euro will weaken in international markets (and inversely the US dollar value will rise).

In both diagrams one can see, that because of the foreign exchange operation the quantity of euros (money base) has changed (Q₁ → Q₂). This would naturally lead to an alteration of € interest rates and thereby monetary policy. From this point of view this is equivalent to a tightening in monetary policy. In part 6.1 of the essay we shall explain in which way a central bank can neutralize this impact on the domestic money base.

So far, it is sufficient to understand the basic mechanism of altering exchange rates. Now this paper will show how this has been the case in the past.

3. Supporting the exchange rate

3.1 The ECB intervention in September 2000

The European Central Bank (ECB) made extensive use of interventions in order to support the euro at its all-time low during September 2000. The ECB conducted, beside the sales of US $ on 14th September, a major intervention by selling US $ on 22nd September^[1]. Diagram 3 shows the development of the US $/€ rate in the three day period of 21/22/25th September adjusted to 1.0 at market opening. For comparison the GBP/€ and the Yen/€ rate have been added. Diagram 4 shows intraday data of the intervention with real rates.

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Diagram3: Intervention on 22nd September2000 (adjusted)

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Diagram4: Intervention on 22nd Septemberwith real exchange rates

A strong reaction of the market participants is recognizable at the time of ECB’s market entry at Frankfurt exchange market (11:00 am). Being named as such by the ECB, the operation was clearly an intervention in order to support the euro. The transaction value was not clearly announced^[2]. The euro value rose from 0.87035 US $ (11:00 am) by 2.74% to 0.8942 US $ (11:20 am). The foreign currency reserves sharply fell from 264,130 billion € in August to 234,233 by end of November (ECB International Reserves, 2000).

3.2 Economic effects

From the diagrams 3 and 4, no sustainable upward trend can be observed in the 1- day post-event phase. Therefore we come to the conclusion that the ECB was not directly able to change the trend. We will come to a deeper analysis of the efficiency in point 5. But since there is a close link between exchange rates and domestic money supply, it might be worthwhile to take a closer look at the interventions economic effects.

- Balance of payments

According to the monthly bulletins published by the ECB (06/2000 - 07/2001), there have been some movements in the flow of capital. Due to a weakening US economy and further interventions of the ECB in November 2000 the changes cannot exclusively be linked to the September intervention. Even though, a decrease of the current account deficit of the euro area to 0.1 billion € in October from the September value of 1.5 billion € can be recognised, due to a reduction in the income deficit. Also slight increases in current and service transfers should be mentioned. Maybe the reduced net outflows of direct investments in October 2000 could account for a temporarily effect of the intervention.

4. Capping the Exchange rate

4.1 The FED intervention in 1985

As an example of an intervention aiming for devaluing the domestic currency we will analyze the operation conducted by the US Federal Reserve (FED) in 1985. After a long period of US $ appreciation in the early 80s, the high value caused major export difficulties for US producers (Craven et al., 1991) and a steady increase of a trade deficit to 145 billion US $ (US Bureau of Census Online Information, 1985). In September 1985 the finance ministry embarked on the dollar value in a concerted intervention coordinated with 4 other countries.

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Diagram 5: FED Interventions during 1977-2002

During the period of 05.10.1985 - 20.10.1985 the Fed and the Federal Exchange Stabilization Fund sold the amount of 1,084 million US $ each, against foreign currencies in order to depreciate the US $ (US Treasury Department, 1985). (For FED data, see diagram 5).

Due to the increased effect by coordination between USA, Germany, Japan, France and UK central banks, referred to as the “group of five” (Craven and Gouchenor, 1991) the depreciation was sustainable over a long-term period (see diagram 6). The dollar weakened by almost 38.5 % during 1985 – 1988 comparing high/low.

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^[1] We focus our analysis mainly on the US$/€ parity. Our data set for the ECB intervention is on intraday basis. The opening rate at 6 am is adjusted at 1.00 in order to make data comparable. Hence deviations are on a per cent basis of exchange rate movements.

^[2] President of the ECB, Wim Duisenberg confirmed on a press conference on 05.10.2000 that the amount of dollars sold, lay within the journalists guess range of 1.5 to 20 billion US $. This secret behaviour corresponds to Bhattacharya and Weller (1997).