Perverse Effects of Non-sterilized Interventions on Spot Foreign Exchange Rates

Abstract

We study the effects of non-sterilized intervention on a spot foreign exchange (forex) rate using a multi-period game-theoretical model which involves an unspeci?ed number of competitive traders, a ?nite number of strategic traders (forex dealers) with heterogenous initial money balances, and the central bank of the home country. Simulating the subgame-perfect Nash equilibrium of the two-stage game played by the forex dealers in each period, we show that the non-sterilized intervention of the central bank may lead to a perverse effect on the spot forex rate. We call the mechanism underlying this effect strategic trade switching channel that works when an increase in the central bank’s forex currency demand (supply) exerts such a big upward (downward) effect on the forex rate that some sufficiently big dealers, who optimally bought (sold) forex currency in the previous period when the forex rate was sufficiently low, ?nd in the current period selling (buying) it more pro?table, thus moving the forex rate in a direction undesired by the central bank. JEL Classi?cation: D43, F31, G20.