Big effects of small interventions: The informational role of intervention in exchange rate policy

Abstract

In this paper we demonstrate how an infintesimal unsterilized foreign exchange intervention may cause a very large discrete change in the exchange rate. We analyze an example in which there is a target-zone policy in place but the actual width of the target zone is not known by participants in the foreign exchange market. In this case, intervention both affects fundamentals and conveys information about policy. The exchange rate jumps in response to intervention with the size of the jump related to the uncertainty about the true band width. Also in this model the relationship between the exchange rate and the fundamental depends upon both the history of the path of the exchange rate and whether or not intervention has occured.