Interdependencies between Monetary policy and Foreign-Exchange Intervention under Inflation Targeting

The bulk of recent literature on foreign-exchange interventions has overlooked the potentialinterdependencies that may exist between these operations and the conduct of monetary policy. This is thecase even under inflation targeting and especially in emerging-market economies, because central banksoften explicitly reserve the right to intervene to calm disorderly markets and to accumulate foreignreserves, and when the exchange rate is perceived as out of step with fundamentals. This paper uses afriction model to estimate intervention reaction functions and the associated marginal effects for Brazil andthe Czech Republic since 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-ratevolatility, while in Brazil the central bank also reacts to exchange-rate deviations from medium-termtrends ii) there are strong, asymmetric threshold effects in the reaction functions, and interventions aremore likely and of higher magnitudes when they are carried out to depreciate than to appreciate thedomestic currency and iii) interventions seem to take place independently of contemporaneous monetarypolicy in Brazil, but not in the Czech Republic, where both policies appear to be interrelated.