M07114 Synoptic Module in International Banking and Finance Oxford Brookes University  

I. Table of Contents

II.  Table of Figures  2

1.  Introduction  3

2.  The mechanism of exchange market operations  3

3.  Supporting the exchange rate  4

3.1  The ECB intervention in September 2000  4

3.2  Economic effects  6

  Balance of payments  6

4.  Capping the Exchange rate  6

4.1  The FED intervention in 1985  6

4.2  Economic effects  8

  Balance of payments  8

5.  Efficiency of interventions  9

6.  Monetary impacts of interventions  11

6.1  Sterilisation of interventions  11

7.  Conclusion  13

III.  Appendix  14

III.a  Endnotes  14

III.b  Tables  16

IV.  Table of Literature  17

IV.a  References  17

IV.b  Bibliography  18

IV.c  Websites  20

  M07114 Synoptic Module in International Banking and Finance Oxford Brookes University  

II.  Table of Figures  

  Diagram 1 : Supporting the currency  3

  Diagram 2 : Capping the currency  3

  Diagram 3 : Intervention on 22 nd September 2000 (adjusted)  5

  Diagram 4 : Intervention on 22 nd September with real rates  5

  Diagram 5 : FED Interventions during 1977 2002  7

  Diagram 6 : Depreciation of US against German Marks during 1985 1990  8

  Diagram 7 : Development of the US trade deficit  8

  Diagram 8 : Development of US Exports  9

  Diagram 9 : Trend of the euro from 1999 2001  10

  Diagram 10 : Enlarged window of the pre- and post-intervention period  10

  Diagram 11 : Changes in foreign currency reserves  12

  Diagram 12 : Development of US Interest Rates  12

  Diagram 13 : Development of US broad money  13

  Diagram 14 : Reaction of the DAX on the Intervention  14

  Diagram 15 : Reaction of the US Stock markets  15

Table 1  : Standard deviation from basic trend after the invention  16

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M07114 Synoptic Module in International Banking and Finance Oxford Brookes University

1. Introduction

After the collapse of the Bretton-Woods-System in 1973 and the transition to a system of floating rates between the major global currencies, central banks still use interventions for exchange rate maintenance. This paper aims to examine the function of Central Bank operations in foreign exchange markets on the basis of two empirical data sets, explaining both, appreciation and depreciation. It tries to analyse the impacts on capital flows recorded in the balance of payments and the efficiency of interventions. Further it will analyse the impacts on domestic monetary supplies and if necessary how to sterilise these effects. At certain stages endnotes will refer to the appendix for more detailed explanations or data.

2. The mechanism of exchange market operations

To illustrate, how central bank interventions work, we will take the European Central Bank (ECB) as an example and concentrate on two currencies, the euro (€) and the US dollar ($).

Diagram 1: Supporting the currency Diagram 2: Capping the currency

Appreciation (see diagram 1)

If the ECB aims at an appreciation of the own currency, the bank will engage in a foreign exchange operation and buy euros against its US dollar reserves. The demand for euros increases (demand curve shifts to the right) and simultaneously

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M07114 Synoptic Module in International Banking and Finance Oxford Brookes University

supply is reduced, because the ECB takes Euro out of the market (supply curve shifts to the left). Through the forces of supply and demand the value of the euro will strengthen in international markets (the exchange rate moves from r 1 to r 2 ).

Depreciation (see diagram 2)

If the ECB aims at a depreciation of the own currency, the bank will sell euros against dollars. In this case, demand for euros declines (demand curve shifts to left) and the supply increases (shift to the right) because the ECB pays the purchased dollars in euro. Again, the forces of supply and demand determine the new exchange rate at r 2 . The value of the euro will weaken in international markets (and inversely the US dollar value will rise).

In both diagrams one can see, that because of the foreign exchange operation the quantity of euros (money base) has changed (Q 1 → Q 2 ). This would naturally lead to an alteration of € interest rates and thereby monetary policy. From this point of view this is equivalent to a tightening in monetary policy. In part 6.1 of the essay we shall explain in which way a central bank can neutralize this impact on the domestic money base.

So far, it is sufficient to understand the basic mechanism of altering exchange rates. Now this paper will show how this has been the case in the past.

3. Supporting the exchange rate

3.1 The ECB intervention in September 2000

The European Central Bank (ECB) made extensive use of interventions in order to support the euro at its all-time low during September 2000. The ECB conducted, beside the sales of US $ on 14 ^th September, a major intervention by selling US $ on 22 ^nd September ¹ . Diagram 3 shows the development of the US $/€ rate in the three day period of 21/22/25th September adjusted to 1.0 at market opening. For

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M07114 Synoptic Module in International Banking and Finance Oxford Brookes University

comparison the GBP/€ and the Yen/€ rate have been added. Diagram 4 shows intraday data of the intervention with real rates.

Diagram 3: Intervention on 22 nd September 2000 (adjusted)

Diagram 4: Intervention on 22 nd September with real exchange rates

A strong reaction of the market participants is recognizable at the time of ECB’s market entry at Frankfurt exchange market (11:00 am). Being named as such by the ECB, the operation was clearly an intervention in order to support the euro. The transaction value was not clearly announced ² . The euro value rose from 0.87035 US $ (11:00 am) by 2.74% to 0.8942 US $ (11:20 am). The foreign currency reserves sharply fell from 264,130 billion € in August to 234,233 by end of November (ECB International Reserves, 2000).

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