Non-Sterilized Interventions May Yield Perverse Effects on Spot Foreign Exchange Rates

Abstract

We study the effects of non-sterilized intervention on a spot foreign exchange rate using a multi-period game-theoretical model which involves an unspecified number of competitive traders, a finite number of strategic traders (forex dealers), and the central bank of the home country. Simulating the subgame-perfect Nash equilibrium of the two-stage game played by the strategic traders in each period, we show that the non-sterilized intervention of the central bank may lead to a perverse result. This result may arise when the intervention becomes strong enough to unintentionally induce some of the strategic traders - who have previously traded in the direction desired by the monetary authority - to optimally switch to the opposite trade direction.