Exchange rate targeting versus exchange rate interventions

We now define a few concepts involving common but often confusing terminology.
Let us start by considering price stability as the final policy objective.

Furthermore, let us restrict our attention to two intermediate targets consistent with the price stability objective: an exchange rate and a rate of inflation.

If both intermediate targets co-exist, they must be set consistently.

By operational targets we understand the levels of interbank interest and exchange rates aimed at by central bank operations, which are transactions with the market that change the central bank’s balance sheet, such as open market operations in domestic liquidity/T-bills and foreign exchange operations.

In common central bank parlance both the operational targets as well as the operations themselves are often referred to as instruments.

The instruments are set so as to achieve the intermediate targets directly associated with price stability, but in addition can follow other intermediate targets, such as certain values for the real exchange rate or output growth.

In accordance with standard practice we will also use instruments interchangeably referring to both operations and operational targets.

It is now useful to distinguish between two types of central bank actions with respect to the exchange rate.

By exchange rate targeting we mean that the central bank adjusts its policy interest rate as an instrument so as to achieve a particular level/path of the exchange rate set as an intermediate target.

By contrast, by exchange rate interventions we understand central bank operations in the FX market whose aim is to affect the behavior of the exchange rate as an operational target/instrument.

As a result, the exchange rate can function both as an intermediate as well as operational target.

For instance, a central bank’s intermediate target maybe a dollar parity, while in the short term it might be willing to allow for temporary deviations owing to market conditions or the business cycle.

While most of the model–based literature studying the role of the exchange rate in monetary policy focuses on exchange rate targeting, our paper focusses on exchange rate interventions, because they introduce the exchange rate as a central bank instrument (in addition to the interest rate).8

However, we analyze and compare both cases.

8:Note that central banks use FX market operations also for other reasons than to affect the exchange rate behavior, e.g. to accumulate FX reserves and to preserve market stability.

In reality, both exchange rate targeting and exchange rate interventions are common and often concurrent.

For instance, the setting of policy interest rates in Hungary before 2008 took into account that the exchange rate must not escape the official bands.9

At the same time, the central bank also intervened in the FX market to defend the exchange rate bands.

In many cases exchange rate interventions are supported by dramatic changes in interest rates to preserve exchange rate bands as an intermediate target, as it happened, for instance, during the speculative attacks on the ERM in 1992 or most recently during the financial crisis (e.g.in Hungary or Serbia).10

On the other hand, exchange rate interventions alone can be enough for targeting inflation, especially for very small and open economies with a strong exchange rate pass-through.

For instance, the regime in Singapore closely resembles such behavior (Parrado, 2004b).


9:See Ersek (2005).
10:On the ERM see Buiter, Corsetti and Pesenti (1997). On Hungary, see IMF (2011b). On Serbia, see IMF (2008b).