Can Central Bank Intervention Stabilize Exchange Rates by Increasing Confidence in Fundamentals?

In this paper we study a relatively new route of effectiveness of central bank intervention. Within our model, the stabilizing impact of fundamentalists on exchange rates depends on the strength of their belief in fundamental analysis. Empirical evidence from a STAR GARCH model confirms that the more the exchange rate deviates from purchasing power parity the lower the number of remaining fundamentalists in the foreign exchange market. Instead of countering the activity of chartists, mean reversion pressure weakens so that strong and persistent periods of misalignments occur. In such circumstances intervention operations of central banks may encourage fundamental trading again. However, our estimation results reveal that the effectiveness of Federal Reserves’ intervention policy was not stable over time. While stabilizing in the post Plaza period, no such effect can be found in the aftermath of the Louvre accord.