Speculative behavior, exchange rate volatility, and central bank intervention

The aim of this paper is twofold. First, to develop a model which helps to explain the high exchange rate volatility observed empirically. Second, to study under which conditions central bank interventions may calm down the foreign exchange market. Based on empirical observations, a model is presented where the agents select in each trading period a trading rule to determine their speculative positions. The agents have the choice between technical and fundamental trading rules. Simulations produce a high variability of the exchange rates, fat tails for returns, and weak evidence of mean reversion. Within this framework, the effectiveness of some intervention strategies is analysed. One result is: “leaning against the wind” may reduce the volatility as long as the dynamics are influenced by trend-following trading strategies. In periods when the agents are uncertain about the fundamental exchange rate, however, supporting a target exchange rate may be the preferable strategy for the central bank to stabilize the market.