Intervention and Exchange Rate Stabilization Policy in Developing Countries

Abstract

AbstractRecent evidence based on event studies demonstrates the short‐run effectiveness of sterilized (non‐monetary) intervention to stabilize exchange rates. This role is especially important for developing economies where currency volatility is frequently tied to unstable market expectations, herding behaviour and contagion, rather than ‘fundamental’ macroeconomic imbalances. Intervention coordinated with several governments is more likely to succeed in moving exchange rates in the desired direction. The Chiang Mai Initiative (CMI) is a step towards greater cooperation on exchange rate management in Asia, but its main component is a limited US dollar swap agreement between Japan and developing economies and is conditional on an IMF financial package. A much stronger political, as well as economic, commitment to intervene in exchange markets than currently embodied in the CMI would be needed to reduce exchange rate volatility in the region and to ward off future speculative attacks. Greater currency stability, in turn, would give developing economies more flexibility to use monetary and fiscal policy to pursue domestic stabilization policy objectives.