Bubbles, Crashes, and Sterilized Central Bank Intervention

Abstract

We study the efficacy of sterilized foreign exchange intervention in a model where exchange rates are pushed away from their fundamental level by a rational bubble. The bubble is sustained by uncertainty about the post-crash price and about the market absorption capacity. We show that the bubble will be sustained in equilibrium if there is a reasonable probability that the bubble might burst in the first period. We then examine how sterilized interventions can change the equilibrium. In particular, we compare announced with secret interventions, when the central bank intervenes only once in the life of the bubble. We find that the degree of central bank commitment in bringing the exchange rate back to its fundamental level is crucial to determine whether the central bank will prefer to announce the intervention or keep it secret. We also study the conditions under which it is optimal to follow a state-dependent strategy where intervention takes place whenever the spot rate diverges from fundamentals by a set amount. Finally, we show that the central bank must gradually increase the size of interventions under a continuous intervention strategy.