Interdependencies between Monetary Policy and Foreign Exchange Interventions under Inflation Targeting: The Case of Brazil and the Czech Republic

Inflation‐targeting central banks often explicitly reserve the right to intervene in foreign exchange markets when the exchange rate ‘deviates from fundamentals’ and/or ‘displays excessive volatility’. In the case of emerging markets, central banks can often ill afford to neglect exchange rate developments when setting monetary policy because of a high pass‐through of nominal exchange rate changes to domestic prices. As a result, interventions and monetary policy are interrelated, a hypothesis that has been overlooked in the literature. To bridge this gap, this paper includes monetary policy indicators in the estimation of intervention reaction functions for Brazil and the Czech Republic since the adoption of inflation targeting. Our main finding is that interventions take place independently of the contemporaneous monetary policy setting in Brazil, but not in the Czech Republic, where both policies appear to be coordinated.