Why the Bank of Israel Intervenes in the Foreign Exchange Market, and What Happens to the Exchange Rate

The Bank of Israel renewed its intervention in the foreign exchange market in early 2008 after about a decade of not intervening. This study examines the effect of the Bank’s purchases on the shekel exchange rate. The two-stage estimation approach provides the opportunity to understand the factors influencing the timing and scope of the intervention. The results of the estimation show that the Bank of Israel’s purchases contributed to a depreciation of the shekel. The average monthly volume of purchases for periods in which the Bank of Israel actually intervened in the market, approximately $830 million, contributed to a depreciation in the nominal effective exchange rate that was larger by about 0.6 percent, compared with a month with no intervention. The level of foreign exchange reserves (relative to GDP) and the deviation of the real exchange rate from its long-term equilibrium level tend to increase the volume of purchases by the central bank. Support for "leaning against the wind" behavior by the central bank was also found. The results suggest that the "signaling channel" is important in explaining the effect of intervention on the exchange rate.