Monash University

Optimal Exchange Market Intervention with Heteroscedastic Exchange Rates

Email address: Shakila.Aruman@buseco.monash.edu.au

Keywords: Foreign exchange intervention, GARCH, VAR

JEL Classifications: C52, F31

Abstract:
In this paper, we use a small open economy model, which optimizes foreign exchange intervention by minimising a loss function comprising output growth and inflation. Theoretical results show that optimal intervention rule is constant over time (See, for example, Roper and Turnovsky (1980)). However, recently, the optimal intervention rule was shown to be time varying (Weymark, 1999), by incorporating the commonly observed GARCH-type nature of exchange rate volatility into the model. This paper provides an empirical analysis of optimal intervention rule for the Australian case. The results indicate that the Australian optimal intervention rule is time varying, and, among others, depends on the exchange rate and its volatility. The model is further explored by comparing the optimal intervention rule and the actual level of intervention undertaken by the Reserve Bank of Australia. Sims'(1980) Vector Autoregression (VAR) methodology is used to obtain the historical decomposition of the target variables, output growth and inflation, to analyse whether the optimal intervention rule induces more favorable economic conditions.

PDF file of paper: aruman.pdf

Session: Applied Econometrics II

Time: Sunday, 8 July, 2:15pm - 3:45pm

Room: C