The efficacy of intervention in a chaotic foreign exchange market: an empirical study in INR-USD exchange rate series

Abstract

The traditional method of containing forex volatility is by proper controlling of domestic interest rate and foreign exchange reserves. Such instruments, however, have often failed raising doubts about the efficacy of central bank intervention in forex markets. Recent literature tries to rescue the policy makers by pointing toward the intrinsic dynamics or more specifically, the possible chaotic nature of forex markets and its policy implications. Since volatility is endogenous and no long-run predictions are possible in a chaotic market, traditional methods of interventions are likely to fail. This paper explores this issue in context of the Rupee-Dollar exchange rate. It finds that the central bank intervention to be indeed ineffective in an inherently chaotic market. Thus, inefficacy of intervention in forex market could possibly be explained in terms of its intrinsic dynamics. These findings call for a changed policy outlook that could consider the non-linear nature of the forex rates to successfully control its volatility.