WHY DO CENTRAL BANKS INTERVENE

Intervention by central banks, in terms of buying and selling foreign currency, has been a major activity in recent years. This paper invest igates the motivations for such policy and the evidence for its effect iveness. We use high quality daily data on the dollar amounts of inter vention by the central banks of the US and Germany. We also use inform ation on agreed G7 target levels for the $/DM and $/Yen nominal exchan ge rates. Daily, nominal dollar exchange rate returns are well describ ed as a Martingale-GARCH process, and we find little evidence that the different types of intervention have had much effect on the condition al mean of exchange rate returns. There is some evidence that interven tion is associated with slight increases in the volatility of exchange rate returns. While little evidence is found for the effectiveness of intervention, the motivations are more clear. In particular, from the application cf probit analysis we find that the probability of interv ention is determined by the magnitude of the deviation of the nominal exchange rate from the agreed target level and, to a lesser extent, by the current volatility of exchange rates. (C) 1997 Elsevier Science L td. All rights reserved.