FOREIGN EXCHANGE INTERVENTION AND FUTURE MONETARY POLICY: SOME EMPIRICAL EVIDENCE ON SIGNALING HYPOTHESIS

K.G. Sahadevan, Ph.D Associate Professor Indian Institute of Management Prabandh Nagar, Off Sitapur Road Lucknow – 226 013 INDIA E-mail: devan@iiml.ac.in Phone: 0522-361889 Fax: 0522-361840

FOREIGN EXCHANGE INTERVENTION AND FUTURE MONETARY POLICY: SOME EMPIRICAL EVIDENCE ON SIGNALING HYPOTHESIS*

ABSTRACT The present study attempts to examine the following questions in the Indian context. Has foreign exchange intervention been successful in stabilizing exchange rate? Has the intervention been sterilized with the objective of maintaining monetary target? Does intervention signal changes in future monetary policy variables? The estimates of the intervention and sterilization equations indicate that the central bank sterilizes a major portion of reserve flow, and purchases US$ when its price in terms of rupee is low and vice versa. The estimates of the money supply process show that purchases (sale) of US$ are correlated with expansionary (contractionary) monetary policy in the future. However, the results from Granger test of causality indicate that intervention does not have any significant causal relationship with monetary variable and exchange rate.

Keywords:

Exchange rate; Central Bank Intervention; Monetary Policy F31; E58

JEL Classification:

1

1993). The portfolio-balance channel explores the impact of changes in relative supply of domestic (change in the quantity of publicly held government debt) and foreign assets due to the intervention operations (Dominguez and Frankel. 2 . The conclusions drawn on the basis of portfolio balance theory. By changing the outstanding supplies of domestic and foreign currency outside assets. However. on the other hand.1 In the case of unsterilized intervention monetary authority buys (sells) foreign exchange due to which its monetary base increases (decreases) by the amount of the purchase (sale). under a simple view. does not directly affect prices or interest rates and hence does not influence the future exchange rate. neutralizes the effect of purchase (sale) of foreign exchange on domestic monetary base by undertaking equal amount of sale (purchase) of domestic currency denominated bonds. There are however two major channels through which the sterilized interventions indirectly affect exchange rate – the portfolio channel and the signaling channel. Through sterilized intervention the central bank. The completely sterilized intervention. the central bank may cause portfolio re-balancing that would lead to exchange rate changes. indicate that under sterilized intervention exchange rate remain unaffected and alter only the currency composition of domestic and foreign assets. by and large.I. Intervention is generally defined as the official purchases and sales of foreign currencies that the monetary authorities of a country undertake with the objective of influencing future currency movements. This is due to the fact that sterilized intervention neutralizes the money-stock effect through an offsetting transaction by the central bank through open market purchase or sale of government securities or by granting more or less credit to commercial banks. as Obstfeld (1988) pointed out a low volume of intervention relative to large daily turnover in the market makes the portfolio channel ineffective to influence the exchange rate. INTRODUCTION The intervention of central bank in foreign exchange market and its impact on exchange rate has been the focus of theoretical and empirical research ever since the introduction of floating exchange rate system.

Section VI concludes the findings of the study.2 However. In this theoretical setting the present paper seeks to answer the following questions empirically. et al.The non-sterilized interventions. REVIEW OF PREVIOUS STUDIES There is extensive literature on the effect of foreign exchange market intervention on exchange rate and future monetary policy variables. it also revises its expectations of the future spot exchange rate. which in turn brings about a change in the current rate. II. Section II briefly reviews the literature on the effectiveness of foreign exchange intervention.. When the market revises its expectations of future money supplies. Has foreign exchange intervention been successful in stabilizing exchange rate? Has the intervention been sterilized with the objective of maintaining monetary target? Does intervention signal changes in future monetary policy variables? These questions have been examined empirically in the Indian context using monthly data on Reserve Bank of India’s (RBI) foreign exchange intervention from June 1995 through May 2001. 3 . The formulation of testable hypothesis and the equations for estimation have been discussed in section IV and section V presents results of the study and discussion. A description on data and variables. and methodology of the study has been presented as appendix. on the other hand. The signaling hypothesis proposed by Mussa (1981) has given a new dimension to this issue triggering voluminous research in recent times. change the monetary aggregates and interest rates due to which exchange rates would be affected in the same way as the domestic open market operations do. Section III carries a description on the international perspective of nature and purpose of intervention. through either monetary. The remainder of the paper is organized into four sections. there has been very little evidence to suggest that intervention consistently and directly affects spot exchange rates. He has argued that interventions induce traders in the market to alter their expectations of future monetary policy or long-run equilibrium value of the exchange rate. It says that foreign exchange intervention is an effective and predictable signal of monetary policy actions. or a portfolio balance transmission channel [Baillie.

Lewis (1995) has examined whether intervention helps predict future changes in monetary policy in the US context. there are attempts to measure the effect of current intervention on the exchange rate over and above the contribution of the current fundamental. is to directly estimate the effect of intervention on changes in expected monetary policy. These Studies differ in the methodologies used.3 Most of the studies in this area are in the US context and are concerned with the effect of intervention on the US$ exchange rates against Japanese Yen and German Mark. Kearney and MacDonald (1986) have examined the potency of sterilized intervention using a portfolio balance model the result of which indicated that sterilized intervention had been effective on British pound-US$ exchange rates. The portfolio channel through which sterilized intervention affect exchange rates. First. on the other hand. Using bivariate vector autoregressions and Grangercausality tests. and that interventions in the yen-dollar market tend to occur in clusters. the most common method has been the estimation of money supply process (equation 2 below) and measurement of the ability of intervention to predict the future course of money supply. which reveals the monetary policy intentions of the central bank through interventions. which has been used in Fatum and Hutchison (1999). The study reports a mixed picture of the 4 . Similarly. has received little empirical support. In the context of UK. The findings of Dominguez and Frankel (1993) have supported the effect of Federal Reserve and Bundesbank intervention on exchange rate through the portfolio channel as against the consensus view thus far that the portfolio channel of intervention had been ineffective.(2000)]. Three different methodologies have been utilized for empirical investigation. the findings of Ramaswamy and Samiei (2000) on the basis of a simple forward looking model of the exchange rate showed that interventions conducted during 1995-99 succeeded in changing the path of the yen-dollar rate in the desired direction. The results from probit model indicated that the Bank of Japan (BoJ) had pursued a symmetrical policy by which both an excessive appreciation and depreciation of the yen provoked interventions. The evidences from most of the studies are in favor of signaling channel. Secondly. The third approach.

attention has been shifted to studying the effect of intervention on exchange rate volatility. In Fatum and Hutchison (1999). Kim et al (2000) came out with similar evidence in the Australian context by showing that sustained and large interventions have a stabilizing influence in the Australian $-US$ market in terms of direction and volatility during 1983-97. Ghose (1992) tested the portfolio balance channel by examining the effects of changes in relative asset supplies on the US$-Deutschemark rate and found a weak. Galati and Melick (1999) studied the impact of the Federal Reserve’s and BoJ’s intervention on the instantaneous and expected volatility (derived from option 5 . Kaminsky and Lewis (1996) have also reported similar results. but sometimes in the opposite direction of that predicted by the conventional signaling hypothesis. but statistically significant. portfolio balance influence on the exchange rate. The nonavailability of data on the rate and volume of intraday sale and purchase of foreign currency undertaken by any central bank however limit the feasibility of profit test.signaling story and finds a circular relationship between intervention and future monetary policy. The study has also used the Wonnacott’s criterion5 the result of which supported the findings of profit test. On the whole. Aguilar and Nydahl (2000) reported results from GARCH models that central bank’s sterilized intervention has not systematically reduced the volatility of Swedish kroner rates against US$ and Deutsch Mark. which indicate that the US intervention provided a signal to future changes in interbank rates and monetary aggregates. Over the past few years. the evidence obtained from GARCH model found dollar intervention not related to a rise in expected future short-term interest rates (monetary tightening). the evidence from these studies on impact of intervention on conditional exchange rate volatility as well as on implied volatility is not very conclusive. They have used the federal funds futures market prices as the proxy for market expectations on future monetary policy. Using the Friedman’s “profit test”4 Andrew and Broadbent (1994) tested the effectiveness of the Reserve Bank of Australia’s (RBA) intervention and showed that RBA has made significant profits from intervention and that intervention has tended to stabilize the Australian dollar exchange rate over the period the currency has been floating. The evidence presented in BonserNeal (1996) on the Federal Reserve’s intervention suggested that the central bank intervention had little effect on volatility.

no currencies in the world are freely floated. III. the Reserve Bank of India (RBI) uses its foreign exchange reserves for market intervention so as to align the market rate of rupee with its desired rate consistent 6 . there is some.prices) of yen-US$ exchange rates and found that the interventions did not have any impact on the forward rates but suggested that it could increase the uncertainty in the movement of spot rates. Since the beginning of floating exchange rate system in 1973. most of the world’s major central banks have intervened frequently and at times forcefully in the foreign exchange markets to influence the path that their respective currencies have taken.. INTERVENTION UNDER FLOATING SYSTEM In its true sense. Although there are no well defined rules governing the motive of intervention. To conclude. the IMF’s Principles for the Guidance of Members’ Exchange Rate Policies describes that “a member should intervene in the exchange market if necessary to counter disorderly conditions which may be characterized inter alia by disruptive short-term movements in the exchange value of its currency”. i. Baillie and Osterberg (1997) found some evidence that intervention leads to increases in volatility and also influences the risk premium in the Deutschemark-US$ and Yen-US$ forward markets. but allows for the possibility that intervention may sometimes influence market expectations about those fundamentals”. by the central bank conveying a signal to market participants about information on future fundamentals that they do not have. In a fairly comprehensive survey of research Baillie et al (2000) concluded that “empirical work to date suggests that exchange market intervention does not directly affect the fundamental economic determinants of exchange rates. However. but no conclusive evidence that intervention mainly works through the signaling channel. They have also reported that intervention is Granger caused by high volatility of changes in the nominal exchange rate and unidirectional from intervention to risk in the forward market. In the Indian context. in addition to the trade and capital controls imposed by the government. However.e. They have concluded that intervention is motivated by increases in spot rather than forward market volatility. there is no general consensus evidence to support the portfolio balance channel.

it signals the intention of the central bank to control the monetary growth and secondly. and vice versa. often outweigh this objective and necessitate official intervention to lean against the wind of short-term exchange rate movements. This official exchange rate management has a conventional objective of ensuring the currency not deviating far away from the long-run equilibrium rate. Whenever yen raised against the dollar. it signals the undesirable changes in exchange rate that are being taken place in the marketplace.. However. other considerations like maintaining export competitiveness. While BoJ intervenes in order to moderate the trends in yen over time. the 7 . creates a mismatch between supply of and demand for money eventually leading to change in exchange rate in the medium term.with certain macroeconomic parameters. “most studies conclude that the direct effect of intervention on exchange rates is either statistically insignificant or quantitatively unimportant” [Rosenberg (1996)]. However. its effectiveness however depends on the volume of intervention relative to the daily turnover in the market. The market intervention has various implications. and it is designed to fulfill certain intentions of the central bank depending on the choice between sterilized intervention and non-sterilized intervention. The sterilized intervention through open market operations offsets the change in net foreign assets by a corresponding change in net domestic assets. This intervention is effective only if its volume is sizable relative to the outstanding stock of domestic money holding. The non-sterilized intervention. The BoJ has consistently pursued a policy of leaning against the wind. on the other hand. This in turn helps the central bank to adhere to monetary targets. lead to correction in exchange rates in the short-term. First. guarding currency against speculation. Though the direct intervention alters the demand and supply forces in the market which. RBI at times resorts to sterilized intervention not essentially to directly affect exchange rate but to give signal in two counts.6 The objectives of intervention differ by country and from one period to the other. the BoJ bought dollars and sold yen to moderate the yen’s rise. These signals eventually force traders with vulnerable long or short positions to abort speculation and bring exchange rate in alignment with its long-run trend rate or to maintain the rates at a desired level. etc.

at times. ∞ j s = (1 − θ ) ∑ θ E f t t t+ j j=0 (1) In the above process for nominal exchange rate. The signaling hypothesis may be illustrated by a standard asset-pricing-model approach to exchange rates. Et is the expectations operator. Bundesbank has compromised this objective in order to get the exchange rate in alignment with its long-run rate. the period between 1981 and 1984 witnessed benign neglect toward dollar’s rise. ft represents the current period fundamentals. since intervention would give the monetary authorities an open position in a foreign currency that would result in a loss if they failed to validate their signals.7 In the case of dollar however Federal Reserve has never maintained a uniform policy for exchange rate management. From 1993 onward. This signaling channel signifies that there is asymmetry of information between the central bank and the market participants on future fundamentals of the exchange rate. Such signals could be particularly credible. Therefore. the current sterilized intervention alters market perception about the future course of monetary policy according to which exchange rate will move even though sterilized intervention currently offsets the monetary effects.Bundesbank does intervene primarily for domestic monetary control. central bank may signal contractionary (expansionary) future monetary policy by selling (buying) the intervention currency in the foreign exchange market today. According to this signaling hypothesis. IV. Federal Reserve has encouraged the dollar to decline. In line with the Plaza Accord dollar was encouraged to decline during 1985-86 while during 1987-92 Federal Reserve promoted greater stability of dollar in line with Louvre Accord. st is the log exchange rate at time t. However. and θ is a 8 . While during 197880 it carried out major intervention to arrest dollar’s decline. THE SIGNALING HYPOTHESIS Mussa (1981) has proposed that interventions are the indications to future course of monetary policy.

nt-k help predict the future value of the fundamental determinant which follows a simple autoregressive process with the intervention signal entering exogenously together with a random disturbance term (µt).discount factor. Following the monetary models of exchange rate. the sale of foreign currency will be correlated with a tight monetary policy in the future. 9 . E f −E f =γ +γ n +ε t +1 t + j t t+ j 0 1 t t (3) where Et+1 ft+j – Etft+j represents changes in expected fundamentals. the process of fundamental is given by f =ρ f +β n +µ t f t −1 t−k t (2) where ρf is the autoregressive coefficient of f on its own lag and β is the coefficient of k period lagged intervention. Similarly.8 Given the hypothesis that intervention at time t-k. the current exchange rate is the expected present discounted value of differences in the relative monetary conditions which are the fundamental determinants of exchange rates. Some of the studies as explained earlier however have utilized the direct approach of estimating the following equation. It signifies that the purchase of foreign currency (which is equivalent to sales of domestic currency) at t-k signals an expansionary monetary policy in the future at time t. The present study has mainly estimated the fundamental process (2) using broad money as the proxy for fundamental and measured the ability of intervention in terms of the β estimate to forecast movements in the fundamental (expected monetary policy is being considered as the fundamental). The hypothesis is that the purchase (sales) of US$ against rupee invokes the expectation of monetary expansion (tightening). The variable n being the central bank’s net purchase of foreign currency (US$) its coefficient β would assume a positive value for the signaling story is to be right.

RBI has turned out to be a net buyer of US$ when rupee was sliding.V. The frequency table and the χ2 test indicate that intervention and exchange rates are interdependent. A positive coefficient for exchange rate in the intervention equation is an indication of the practice of leaning against the wind which means that central bank prevents further appreciation (depreciation) of rupee by purchase (sale) of US$./US$) in the intervention equation signifies that the central bank purchases US$ when its price in terms of Indian rupee is low and vice versa. between October 1998 and March 1999 rupee depreciated from 42. Ideally. the monetary growth and currency value should move in opposite directions i. The test of central bank’s policy of ‘leaning against the wind’ has been carried out by estimating an intervention equation.43/US$ while RBI has undertaken a net purchase of dollar to the tune of Rs. The statistically significant and negative coefficient of exchange rate (Rs.25/US$ to 42. As the figure shows.. Thus the visual examination of the exchange rate and intervention data essentially indicates the fact that intervention has not been aiming at maintaining exchange rate or alternatively it has not been sufficient enough to pull the exchange rate in desired direction. if the transmission mechanism works. The period 10 . it would be interesting to note from the figure-1 that the exchange rate remained more or less stable during 1996:4 – 1997:10 and 1998:8 – 2000:4 when RBI continued to be the net buyer of US$ from the market during the former period while it was not a consistent buyer during the later period. positive growth in money supply should be offset by depreciation of exchange rates. 10. However. the variation in monetary base found to have insignificant influence on the intervention decisions. Moreover. EMPIRICAL TEST AND DISCUSSION OF RESULTS The table-1 and 2 contain the results of various tests. But the movement of exchange rate has not largely been in the direction that intervention ideally leads to. The figure-2 further confirms the fact that exchange rate (and intervention) does not reflect the monetary conditions.879 during this period. For instance.e. It is observed that in 48 cases out of 70 data points rupee appreciated (depreciated) when RBI was the net buyer (seller) of US$ while it moved in the expected direction in only 22 cases.

rupee closed at 34. and thereafter it was stabilized. Further.9 Following Genberg (1976).of stable exchange rate between March 1993 and August 1995 has been the period of wild fluctuations in money supply growth ranging between 14 per cent to as high as 22 per cent. The direct approach of testing signaling hypothesis using equation (3) has also not provided substantive evidence to confirm that intervention signals future monetary conditions. A very low coefficient value of lagged intervention in the estimated equation indicates that it has only a marginal impact on money supply. The test of signaling hypothesis is based on the estimates of the equation (2) in which money supply is being used as a proxy for the fundamental factor ft. the result shows that.00/US$ until July 1997. Though money supply has not grown beyond 16 per cent during this period. a standard sterilization equation has been estimated to see what extent the central bank sterilizes reserve flows. which signifies that RBI sterilizes a major portion of reserve flow.23.50/US$ to 42. The results from test of causality indicate that intervention does not have any significant causal relationship with monetary variable and exchange rate. In spite of this. The estimated coefficient values of foreign currency reserves (sterilization coefficient) and central bank’s net credit to government in the sterilization equation capture the thrust of monetary policy to sterilize the impact of reserve flows on monetary base. Under complete sterilization. rupee depreciated subsequently to move from 36. The positive coefficient of lagged intervention signifies that purchases of US$ are correlated with expansionary monetary policy. There is some supporting evidence to the signaling hypothesis as well.50/US$ between August 1997 and June 1998. the fall in rupee value was on account of declining capital inflow and weak export growth. as expected. intervention causes changes in the level of foreign currency reserves. However. the estimated sterilization coefficient is 0. In September 1995. rupee remained relatively stable at around 31. the coefficient of reserves would be –1 and in the absence of sterilization its value would be zero. 11 . A tighter monetary policy during 1995-97 has brought down the growth of money supply to around 16 per cent on an average. However.00/US$ and subsequently remained stable at around 35.50/US$ until August 1995.

VI. the result showed that the central bank accumulates foreign currency when it is cheaper and offloads when it is dearer in terms of domestic currency. Conclusion The present study has attempted to empirically examine the impact of central bank’s intervention on exchange rate and future monetary policy in the Indian context. for signaling future course of monetary policy. The central bank however has used intervention. though not very significantly. any study in the above directions would ideally use the daily exchange rate and intervention data.This gives an indication to the fact that RBI has not been buying (selling) dollars when rupee becomes stronger (weaker) and reserve level rises (falls). The monthly data as has been utilized by the present study owing to the non-availability of daily intervention data limited the results of the study to certain extent. To conclude. It is emerged from the analysis that the intervention did not have stabilizing effect on exchange rate. 12 . On the contrary.

01 (7.003 0.76 (0.23) 23 22 0 25 70 19. One.Table-1: χ2 Test and Estimated Regression Equations χ2 Test Number of months that Rs.1* R2 = 0. two and three asterisks indicate significance at 1%.04) Sterilization equation bt = α + β1 rt + β2 gt + εt 0. D-W is the Durbin-Watson statistic and values in parentheses indicate t-statistic.01)** (1.31 SEE = 0.36 (-3. mt+1 – mt = α + β1 nt + εt 0.27 (0.36) (1.21 SEE = 0. mt = α + β1 mt-1 + β2 nt-1 + εt 0.96) (3.008 D-W = 2.88)*** R2 = 0.05 SEE = 0.5)* (1.02 D-W = 2./US$ rate Appreciated when RBI is net buyer of US$ Depreciated when RBI is net buyer of US$ Appreciated when RBI is net seller of US$ Depreciated when RBI is net seller of US$ Total Chi-square Estimated Regression Equations Intervention equation nt = α + β1 st + β2 bt + εt 0.90)*** R2 = 0.02 -0. ρ is the first order autoregressive parameter.01 (13.01 ρ = -0. 5% and 10% levels respectively. 13 .20 Test of Signaling Hypothesis 1.14 -4.41)* (-0.44) (-2.09 Refer appendix for definition of variables and their notations.42 1.01 2.043 0.79)* R2 = 0.24 0.51)* (4.05 SEE = 0.29 D-W = 2.008 D-W = 2.01 0.

003.05 (-0.63 (-2. F-statistic F(2.74) 0.44) 0. F-statistic F(2.17) -0. 64) = 1.18.95) nt-2 0.94 st nt st-1 0.098 (-0.454) nt-1 -0. F-statistic F(2.31) -0.20 (1.005) st-2 -0.85) nt-2 0.20 (-1.106 The values in parentheses indicate t-statistic.40) nt-1 0.12 (-0.77 P-value for mt causes nt: 0.49) mt-2 -0.33 (0.07 (0.19 (0. 64) = 0.14 (-0. 64) = 0.19 (1. 64) = 0.732 P-value for st causes nt: 0.006 (-0.82.029 (1.49.11) nt-2 -0. F-statistic F(2.38) 2.196 rt nt rt-1 -0.56 (-3.67) -0.47) P-value for nt causes rt: 0.741) P-value for nt causes st: 0. F-statistic F(2.0004 (-0.01 (1.41 (-3.58) 1.013 (0. 64) = 3.58 (-0.106) -0.Table-2: Results of Granger Causality Test mt nt mt-1 -0. 64) = 6.899.029 (-0.54) -0. 14 . F-statistic F(2.60) -3.23) -1.37) nt-1 0.53 P-value for rt causes nt: 0.90) P-value for nt causes mt: 0.002 (0.96) -0.389 (-2.024.067 (3.74 (-0.74) rt-2 0.

Crore) 12500 17500 7500 2500 -7500 1995 6 1995 8 1995 10 1995 12 1996 2 1996 4 1996 6 1996 8 1996 10 1996 12 1997 2 1997 4 1997 6 1997 8 1997 10 1997 12 1998 2 1998 4 1998 6 1998 8 1998 10 1998 12 1999 2 1999 4 1999 6 1999 8 1999 10 1999 12 2000 2 2000 4 2000 6 2000 8 2000 10 2000 12 2001 2 2001 4 -2500 Rs/US$ rates US$ Purchase Figure 1: RBI's Intervention and Exchange Rate Movements Year and Month 15 0 5 10 15 Rs/US$ exchange rates 20 25 30 35 40 45 50 .US$ Purchase by RBI (in Rs.

00 18.00 M3 growth Rs/US$ rates 15 20 25 30 35 40 45 50 Figure 2: Monetary Growth and Exchange Rates Year and Month 16 M3 growth rates .00 16.00 22.00 14.00 20.Rs/US$ Rates 10 1995 6 1995 9 1995 12 1996 3 1996 6 1996 9 1996 12 1997 3 1997 6 1997 9 1997 12 1998 3 1998 6 1998 9 1998 12 1999 3 1999 6 1999 9 1999 12 2000 3 2000 6 2000 9 2000 12 2001 3 10.00 12.00 24.

S. Friedman in his seminal work on flexible exchange rate system has argued that a central bank which was stabilizing the exchange rate would tend to buy foreign exchange when its price was low. After the formal unification of Europe. 7.ENDNOTES 1. e. timing. Tarapore recommended that a REER-monitoring band be declared to enable the participants to anchor expectations on when RBI would intervene and when it would not for making its intervention more effective [Tarapore (1997)]. 17 . Against the consensus view in the early 1980’s that central bank intervention is ineffective. S. 5. Taking the cue from this intervention rule it is argued that the existence of profits over long periods provides a strong case for the view that central bank intervention has been effective in stabilizing the exchange rate. In the light of these findings. 6. 2. Neely (2000) which deal with mechanics. and sell when its price was high. the Committee on Capital Account Convertibility in India headed by Shri. instruments and purpose of secrecy of intervention which are not being reviewed here. Dominguez and Frankel (1993) in their seminal study argue that when the authorities are prepared to intervene at a particular upper or lower limit they will achieve a higher degree of success in stabilizing the currency with a smaller amount of intervention if they publicly announce these limits ahead of time. This study is the most recent one to offer a fairly comprehensive survey of research in the area of central bank intervention. Reserve Bank of India uses US$ as the intervention currency which is being bought and sold against Indian rupee in the market. In the Indian context. 3.g. 4.. The test proposed by Wonnacott (1982) indicates that intervention is stabilizing if it reduces the variance of exchange rate around its trend. Bundesbank implements exchange rate policy and conducts foreign exchange operations consistent with the provisions of Article 109 of the Treaty of European Union. and hence its operations would be profitable. It involves measuring whether the direction of intervention is consistent with pushing the exchange rate back towards its long-run moving average. There are also studies.

The ordinary least square (OLS) method is used for estimating the equations specified in section IV. foreign exchange reserves (r) is the rupee value of foreign currency assets with RBI. In the formulation of ft. 18 . monetary variable and foreign exchange reserves has been tested using Granger test which is based on a simple logic that a variable Y is caused by X if Y can be predicted better from past values of Y and X than from past values of Y alone. The intervention variable (n) is the rupee equivalent of monthly net purchase (positive values)/net sales (negative values) of US$ by the Reserve Bank of India in the spot and forward segments. APPENDIX Definition of Variables and Methodology of the Study The present study has been carried out on monthly data for a period starting from June 1995 through May 2001. The choice of starting period of the sample coincides with the availability of data on RBI’s intervention. The impact of monetary policy on the behavior of rupee exchange rate and international reserves in the Indian context has been empirically examined in Sahadevan (1999) using Girton-Roper model of exchange market pressure.8. The sources of data are RBI Bulletin and RBI Handbook of Statistics on Indian Economy. 9. Therefore. it is assumed that the growth of money supply in rest of the world was constant. In those cases where serial correlation is detected. The possibility of serial correlation problem has been verified by using Durbin-Watson test statistics the values of which are reported against all estimated equations. broad money (m) i. the coefficient estimates are adjusted by using Cochrane-Orcutt method and the first order autoregressive parameter (ρ) is reported along with its t-statistics. and central bank’s net credit to government (g) is the central government’s net borrowings from RBI.e. The causality between intervention. ft represented the change in money supply conditions in the domestic economy alone. The variables used in the study are defined as follows: reserve money (b). exchange rate (s) is the monthly average rate of the rupee vis-à-vis US$ which is measured in rupees per unit of US$. M1 plus time deposit liabilities of banks.

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