Exchange Rate Dynamics Under Alternative Intervention Rules

Recent research on exchange rates have incorporated short-run intervention rules into models assuming rational expectations. Most of the papers focus only on a particular intervention rule, either the leaning against the wind policy (nominal exchange rate rule) or the policy of stabilizing the real exchange rate (real exchange rate rule). The objective of this paper is to examine the effects of these two alternative short-run intervention rules on the behavior of a small open economy. Using the Dornbusch (1976) model modified to allow for imperfect asset substitution, we analyzed how the system responds to a given disturbance under each intervention rule. We show that these two intervention rules differ in that the nominal exchange rate rule can only moderate the movement of the nomical exchange rate while the real exchange rate rule can reverse the movement of the nominal exchange rate and, consequently, they differ in terms of the resulting size of exchange rate jump, speed of adjustment, and relationship between the exchange rate and the interest rate movements. These differences are important considerations for the choice of an exchange rate policy in a small open economy.