RUHR. Foreign Exchange Market Interventions and the $- Exchange Rate in the Long Run ECONOMIC PAPERS #428. Joscha Beckmann Ansgar Belke Michael Kühl

Transcription

1 RUHR ECONOMIC PAPER Joscha Beckmann Ansgar Belke Michael Kühl Foreign Exchange Marke Inervenions and he $- Exchange Rae in he Long Run #428

2 Imprin Ruhr Economic Papers Published by Ruhr-Universiä Bochum (RUB), Deparmen of Economics Universiässr. 150, Bochum, Germany Technische Universiä Dormund, Deparmen of Economic and ocial ciences Vogelpohsweg 87, Dormund, Germany Universiä Duisburg-Essen, Deparmen of Economics Universiässr. 12, Essen, Germany Rheinisch-Wesfälisches Insiu für Wirschafsforschung (RWI) Hohenzollernsr. 1-3, Essen, Germany Ediors Prof. Dr. Thomas K. Bauer RUB, Deparmen of Economics, Empirical Economics Phone: +49 (0) 234/ , Prof. Dr. Wolfgang Leininger Technische Universiä Dormund, Deparmen of Economic and ocial ciences Economics Microeconomics Phone: +49 (0) 231/ , Prof. Dr. Volker Clausen Universiy of Duisburg-Essen, Deparmen of Economics Inernaional Economics Phone: +49 (0) 201/ , Prof. Dr. Chrisoph M. chmid RWI, Phone: +49 (0) 201/ , Ediorial Offi ce abine Weiler RWI, Phone: +49 (0) 201/ , Ruhr Economic Papers #428 Responsible Edior: Volker Clausen All righs reserved. Bochum, Dormund, Duisburg, Essen, Germany, 2013 IN (online) IBN The working papers published in he eries consiue work in progress circulaed o simulae discussion and criical commens. Views expressed represen exclusively he auhors own opinions and do no necessarily reflec hose of he ediors.

3 Ruhr Economic Papers #428 Joscha Beckmann, Ansgar Belke, and Michael Kühl Foreign Exchange Marke Inervenions and he $- Exchange Rae in he Long Run

4 Bibliografische Informaionen der Deuschen Naionalbibliohek Die Deusche Bibliohek verzeichne diese Publikaion in der deuschen Naionalbibliografie; deailliere bibliografische Daen sind im Inerne über: hp://dnb.d-nb.de abrufbar. hp://dx.doi.org/ / IN (online) IBN

5 Joscha Beckmann, Ansgar Belke, and Michael Kühl 1 Foreign Exchange Marke Inervenions and he $- Exchange Rae in he Long Run Absrac This paper ries o clarify he quesion of wheher foreign exchange marke inervenions conduced by he Bank of Japan are imporan for he dollar-yen exchange rae in he long run. Our sraegy relies on a re-examinaion of he empirical performance of a moneary exchange rae model. This is basically no a new opic; however, we pu our focus on wo new quesions. Firsly, does he consideraion of periods of massive inervenions in he foreign exchange marke help o uncover a poenial long-run relaionship beween he exchange rae and is fundamenals? econdly, do Forex inervenions suppor he adjusmen owards a long-run equilibrium value? Our overall resuls sugges ha aking periods of inervenions ino accoun wihin a moneary model does improve he goodness of fi of an idenified long-run relaionship o a significan degree. Furhermore, Forex inervenions increase he speed of adjusmen owards long-run equilibrium in some periods, paricularly in periods of coordinaed forex inervenions. Our resuls indicae ha only coordinaed inervenions seem o sabilize he dollar-yen exchange rae in a long-run perspecive. This is a novel conribuion o he lieraure. JEL Classificaion: E44, F31, G12 Keywords: rucural exchange rae models; coinegraion; inervenion analysis July Joscha Beckmann, Universiy of Duisburg-Essen; Ansgar Belke, Universiy of Duisburg-Essen and IZA Bonn; Michael Kühl, Deusche Bundesbank. We are graeful for valuable commens from paricipans a he 10h Biennial WEA Pacific Rim Conference, he Göinger Workshop Inernaionale Wirschafsbeziehungen and he 17h Inernaional Conference on Macroeconomic Analysis and Inernaional Finance. We also grealy appreciae helpful commens from Rasmus Faum. The views expressed in his paper are hose of he auhors and do no necessarily reflec he opinions of he Deusche Bundesbank. All correspondence o Joscha Beckmann, Universiy of Duisburg-Essen, Deparmen of Economics, Universiässr. 12, Essen, Germany, joscha.beckmann@uni-due.de.

6 1. Inroducion The dollar-yen exchange rae has been he subjec of conroversy for more han hiry years. ince he breakdown of Breon-Woods, he Japanese auhoriies have inervened more heavily in he foreign exchange rae marke han hose in any oher indusrialized counry. Alhough i is recognized ha he Bank of Japan has generally followed a sraegy of leaning agains he wind o minimize exchange rae movemens, some auhors have claimed ha he early Japanese policy is biased owards limiing yen appreciaion (Huchinson, 1984). In July 2001, he Japanese Minisry of Finance published is daily inervenion daa going back o ince hen, many researchers have focused on hree differen issues: he effecs of inervenions on he exchange rae level, is impac on exchange rae volailiy and he moivaion for moneary auhoriies o inervene (Hoshikawa, 2008). As will be illusraed below, he presen sudy analyzes he impac of inervenions from a new perspecive, deparing from he firs-menioned srand of he lieraure and focusing on he long run. Hence, we will briefly describe he lieraure wih regard o his opic before describing our specific conribuion. 2 The quesion of wheher inervenions are effecive in influencing he level of he exchange rae has been discussed conroversially. However, arno and Taylor (2001) claim ha he lieraure delivers more evidence in favor of effeciveness in foreign exchange inervenions in general. This is also rue for Japan, alhough he evidence remains mixed. ome resuls sugges ha inervenions underaken by he Japanese auhoriies have been effecive (Dominguez, 2006; Taylor, 2005; Reiz and Taylor, 2012). 3 The findings of Faum and Huchinson (2005) provide evidence ha even serilized inervenions by he Japanese auhoriies do influence he exchange rae. However, heir effeciveness seems o depend on he horizon under observaion in he sense ha he impac of inervenions disappears a longer horizons (Frazscher, 2009b). Frazscher (2009b) argues ha he credibiliy of auhori- 1 The Foreign Exchange and Foreign Trade Law sipulaes ha he Miniser of Finance shall endeavor o sabilize he exernal value of he yen hrough foreign exchange rading and oher measures (Aricle 7.3). Moreover, he Miniser of Finance is legally auhorized o conduc inervenion as a means o achieve foreign exchange rae sabiliy. The Bank of Japan, as he agen of he Miniser of Finance, execues foreign exchange inervenion. ee Volz, and Fujimura (2011) for a deailed discussion. 2 Wih regard o exchange marke inervenions and heir impac on volailiy, from a heoreical poin of view credible Cenral Bank inervenions, especially when hey are coordinaed, should reduce exchange rae volailiy. The opposie should be rue for non-credible arrangemens (Frenkel e al., 2005; Dominguez, 1998). However, he resuls regarding his issue are no clear-cu. For sudies relaed o his issue see Dominguez and Frankel (1993), Frenkel e al. (2005), Waanabe and Harada (2006) and chnabl and Hillebrand (2008), among ohers. 3 Taylor (2005) applies a Markov swiching approach o he yen-dollar exchange rae over he period beween April 1992 and December His resuls sugges ha inervenions are effecive, as hey increase he probabiliy of real exchange rae sabiliy. Reiz and Taylor (2012) uilize a smooh ransiion GARCH model for he period 1980 o 2004, which allows for non-lineariies in he adjusmen process. 4

7 ies plays a major role in he success of forex marke inervenions. Furhermore, as Taylor (2005) shows, effeciveness seems o be increase wih he degree of misalignmen. In general, one aim of inervenions is o achieve exchange rae sabiliy a a level ha is broadly consisen wih fundamenals (arno and Taylor, 2001). This view is consisen wih he fac ha he Japanese auhoriies seem o inervene when he exchange rae has exceeded specific arges (Io and Yabu, 2007). By esimaing reacion funcions, Io (2003) idenifies several possible aims of inervenions and concludes ha acions underaken in he exchange marke by he Japanese auhoriies were effecive beween June 1995 and March 2001, while his was no he case from April 1991 o May From his seing, he findings of Io and Yabu (2007) sugges ha Japanese inervenions indeed followed a paern of leaning agains he wind, as large changes seem o cause conrary inervenions. This implies ha he BoJ had a arge value in mind. This paper conribues o his debae by focusing on a quesion which has mosly been negleced in he empirical lieraure: he imporance of inervenions in a long-run perspecive. If Japanese exchange rae policy has followed a sraegy of leaning agains he wind and aimed a resricing non-fundamenal exchange rae flucuaions, which are also based on a long-run exchange rae arge, he following quesion arises: Is here any influence on he long-run link beween he exchange rae and fundamenals which sems from inervenions in he foreign exchange marke? To be more precise: do periods of massive inervenions need o be accouned for when modeling he long-run relaionships beween he exchange rae and fundamenals? This is he cenral quesion we address in his sudy. If inervenions are imporan in he long-run, accouning for hese periods should no only help disenangle he link beween he exchange rae and fundamenals. The adjusmen owards he equilibrium pah should also be faser in hese periods. Inervenions usually occur when he exchange rae has roughly depared from is long-run level. Given ha moneary auhoriies have privae informaion abou he fundamenal level of he exchange rae, inervenion periods can be used o proxy periods in which he exchange rae does no follow is fundamenal pah. By no aking his influence ino accoun, he long-run relaionship found empirically, as long as one can be idenified, is severely biased. In addiion, if inervenions are successful and do limi he influence of noise raders by pushing exchange raes back o heir fundamenal values, his would end o suppor a mean revering behavior in he exchange rae which, in urn, would correspond o a break in he adjusmen coefficiens (see, e.g., Alavilla and De Grauwe, 2010, for he main argumen). In his spiri, Juselius and Mac- Donald (2004) analyze pariy relaions beween he Unied aes and Japan. They argue 5

8 ha he cumulaive impac of moneary inervenion shocks is likely o describe an addiional sochasic rend. When focusing on he long-run relaionship beween he exchange rae and fundamenals, we obviously disregard feaures ha are imporan in he conex of exchange rae inervenions such as he impac on volailiy or insabiliy issues regarding parameers. 4 However, hese shorcomings are jusified on he grounds ha our research opic is novel and we are aiming o model a sable long-run relaionship by aking inervenions ino accoun. From a policy poin of view, he quesion of wheher periods of massive inervenions have had an impac on he coinegraing relaionship beween he exchange rae and fundamenals is also imporan, since he impac of inervenions on long-run relaionships may also be inerpreed as a measure of effeciveness. To pu our opics of invesigaion under closer scruiny, ecion 2 proceeds wih a heoreical consideraion of inervenions in srucurally reduced exchange rae models and we idenify regimes of heavy inervenions underaken by he Japanese auhoriies in he dollar-yen marke. 5 In ecion 3 we apply he coinegraed VAR approach of Johansen and Juselius o assess wheher hese periods should be accouned for in he coinegraion vecor and invesigae wheher he speed of adjusmen ha we find owards he long-run equilibrium is faser during periods of inervenions. ecion 4 concludes. 2. Economic mehodology 2.1 Foreign exchange marke inervenions in heory Four cases can be disinguished wih regard o he characerizaion of inervenions. Inervenions may be carried ou in a serilized or unserilized fashion and may or may no be made publicly available. Furhermore, i is possible ha marke paricipans acually perceive inervenions when no acual inervenions have occurred or if policymakers deliver an oral saemen wihou acually inervening. Wih respec o he ransmission of inervenions, hree channels can be idenified. The porfolio balance effec arises when inervenions change he relaive supply of domesic o foreign asses which are assumed o be nonperfec subsiues. If inervenions are successfully serilized (wih respec o money supply) such an effec coninues o hold in conras o he case of perfec subsiues. The signaling 4 Beckmann e al. (2011) do, indeed, find significan parameer insabiliy in coinegraion regressions among he dollar-yen exchange rae and fundamenals. 5 As described in secion 3, including inervenion periods of he Fed urned ou o insignifican wihin our framework. 6

9 channel arises from he fac ha policymakers provide marke paricipans wih new informaion, for example wih respec o he fuure policy pah, in cases of inervenions. This mechanism migh also be imporan in he case of serilized inervenions (arno and Taylor, 2001; Faum, 2009). The coordinaion channel sems from a micro-based model. The idea here is ha in a heerogeneous agen framework i is difficul for fundamenal raders o make use of deviaions in he exchange rae from a fundamenal value because heir rade horizon may no be sufficien o exploi arbirage opporuniies. This can be undersood as a coordinaion failure. If he marke sees he Cenral Bank as an agen wih superior informaion, he announcemen of inervenions effecively acs as a coordinaing signal o fundamenal raders. In addiion, he relaive profis of agens are changed such ha he arbirageurs ener he marke, which in urn suppors he reurn of he exchange rae o a level consisen wih fundamenals (Reiz and Taylor, 2008, 2012; arno and Taylor, 2001; Frazscher, 2008). By definiion, ransmission hrough he signaling and coordinaion channels does no occur when paricipans are unaware of inervenions and when no oral saemens have been made. In general, he decision in favor of inervenions migh be based on he belief in a specific fundamenal value. Almekinder and Eijffinger (1996) and Io and Yabu (2007) suppor his view wih he help of reacion funcions derived from a heoreical framework which consiss of cos-minimizing behavior by he moneary auhoriies while aking a arge exchange rae ino accoun. Beine e al. (2009), for insance, use pas exchange rae variaions in a similar fashion as a measure of misalignmen of he exchange rae from a fundamenal value and as an empirical measure of inervenions. Non-fundamenal impacs on he exchange rae ypically lead o a deviaion from an exchange rae arge defined in erms of a long-run equilibrium beween he exchange rae and is fundamenals. Arbirageurs usually bring he exchange rae back o is fundamenal value so ha he equilibrium is preserved. However, arbirage canno be achieved if he rading horizon of he arbirageurs is shorer han ha of he noise raders. In addiion, i may be raional o follow a rend o generae excess reurns. In such a case, he adjusmen process usually linked wih arbirage is abandoned and he exchange rae shows slow or no selfadjusing behavior. As a consequence, he Cenral Bank decides o inervene if he exchange rae has deviaed o a specific exen (κ ) from is arge level ha can be inerpreed as a fundamenal value (Equaion (1)): T INT = φ 1 for 1 1 > κ T 1 (1) 7

10 The hreshold erm κ in Equaion (1) may well reflec he policy coss menioned by Io and Yabu (2007). 6 Inervenions ( INT ) are herefore relaed o periods of massive deviaions in he exchange rae from is fundamenal value. The coefficien φ capures he inensiy wih which he Cenral Bank reacs o deviaions from he arge level. 7 Long periods of deviaions from he fundamenal value do no only affec he adjusmen owards long-run equilibrium beween he exchange rae and is fundamenals. The long-run relaionship iself can also be disored. The reason for his is ha he rue link beween he exchange rae and is fundamenals is los. The only way o obain he long-run equilibrium in an empirical invesigaion is o ake explici accoun of he non-fundamenal impac. A common soluion o he problem of quanifying such periods is o include dummy variables in he long-run relaionship. The following consideraions moivae his proceeding. If nonfundamenal facors are a work, he exchange rae consiss of he fundamenal par and he deviaions from he fundamenal pah, wih he laer summarized in Z : ' ' = + Z = β X + Z = β X + Z + Z. (2) long nf f Deviaions from he equilibrium pah can furher be spli ino a non-fundamenal par nf Z and f a fundamenal par Z (Equaion (2)). The laer can be undersood as hose deviaions which will be removed by arbirageurs (even when hey are non-fundamenally iniiaed). From Equaion (1) we can derive ha inervenions ( INT ) occur in cases of deviaions from a arge so ha Z and in paricular nf Z, as non-fundamenal deviaions, can be linked o he degree of inervenions (neglecing, for simpliciy, a hreshold, as in Eq. (1)). Assuming ha inervenions in erms of purchases or sales of he domesic currency ake place, and we are ineresed only in capuring he baseline effec, we can divide he periods of deviaions from he fundamenal value up ino periods in which inervenions occur ( INT k Z wih INT k denoing he k -h period of inervenions) and periods wihou inervenions, summarized in NO INT Z INT INT k NO INT, such ha Z = ( Z 1,..., Z, Z ). The erm NO INT Z akes he value 0 when inervenions occur. In doing so, we are able o relae specific periods of inervenions o deviaions in he exchange rae from he fundamenal value. 6 I is assumed ha he arge exchange rae coincides wih he fundamenal exchange raes. 7 In conras o Io and Yabu (2007), we draw on he absolue deviaions from he arge value because we are no ineresed in he direcion of inervenions a his poin. 8

11 Z INT k INT 1 = 0 ( T T ) k sar where ( T T ) k end if oherwise INT 0 wih k = 1,..., K, 1 k sar k end is an indicaor funcion ha akes he value one for he defined period and zero oherwise. Wihou knowing he exac degree of inervenions we can build a k variable I ha is able o capure he k -h period of inervenions, such ha (3) INT-k k 1 for Z 0 I = for k = 1,..., K. INT k 0 for Z = 0 (4) All periods of inervenions covered by he inervenion dummies can be summarized in he vecor I. Wih is help, Eq. (2) can be rewrien, so ha = β ' X + δ ' I + u (5) arises, where δ is a vecor of weighing coefficiens and u comprises all deviaions from he fundamenal value while no inervenions occur. Equaion (5) can be direcly compared f wih Equaion (2). The erm u reflecs he process Z and he inervenion par δ ' I he non-fundamenal impac which is assumed o be known by he policy maker. Now, here are wo possible oucomes which may indicae successful inervenions. The firs is ha he k -h parameer δ in Eq. (5) is zero. Knowing ha inervenions have occurred, his could imply ha he inervenions are enirely successful because he long-run equilibrium is preserved. The second possibiliy is ha he k -h coefficien δ in Eq. (5) shows he direcion of he deviaion from he arge value while he deviaion iself, i.e. he equilibrium error, shrinks. uch an oucome indicaes ha he Cenral Bank has correcly idenified non-fundamenal deviaions from a fundamenal value. Owing o he fac ha insignificance may also be due o nonsuccessful inervenions, we focus on significan inervenion periods when evaluaing our empirical resuls. 2.2 Modeling he long run In order o idenify a possible fundamenal value of he exchange rae, i is necessary o consider an economic heory. In he lieraure concerned wih ineracion models beween fundamenals-based raders and noise raders, purchasing power pariy is ofen seen as he baseline model (Frenkel e al., 2005; De Grauwe and Grimaldi, 2006; Reiz and Taylor, 2008, 2012). omeimes, he fundamenal value is based on a model which conains only money supply and real income wih uni elasiciies (following for insance Mark, 1995). We base our heoreical consideraions on a reduced form of he exchange rae deerminaion model ha 9

12 sems from he class of moneary models. We feel legiimized o argue ha he Cenral Bank evaluaes he fundamenal value of he exchange wih he help of a broader se of fundamenals. The basic form of he moneary model in log form can be wrien as (Frenkel, 1976; Frankel, 1979; MacDonald and Taylor, 1994): f f f f f f μ + β1m β1 m β 2 y + β 2 y + β 3i β 3 i = (6) where μ is a consan, m represens he money supply, y real income and i he ineres raes; f sands for foreign variables. A rise in he exchange rae corresponds o a depreciaion in he domesic currency. By using he moneary model as presened in Equaion (6) i is assumed ha he real exchange rae is consan in he long run. However, in realiy his is generally no rue. Moreover, he PPP is usually consruced using he consumer price index, which sars from he assumpion ha i holds for a mixure of raded and non-raded goods. ricly speaking, he PPP is a concep for raded goods, so he prices of raded goods mus be aken ino accoun (Dornbusch, 1976). Assuming ha PPP holds for radable goods and he domesic price level is an average of non-raded and raded goods, we can rewrie Equaion (6) o add o our model he raios of (domesic and foreign) radable prices o non-radable prices: ( p ) f f f f f f f f f p f = μ β1m β1 m β2 y β2 y β3i β3 i β4π β4 π β5 β n 5 (7) n f p ( p ) wih π as he inflaion rae, which serves as a measure of inflaion expecaions. The las wo erms, namely he wo raios of raded o non-raded goods (domesic and foreign), reflec he real exchange rae. The domesic currency appreciaes when he price of radables increases relaive o ha of non-radables. Consequenly, our model is able o respond o produciviy differenials beween counries, i.e. he well-known Harrod-Balassa-amuelson effec (Harrod, 1939; Balassa 1964; amuelson 1964). 8 A reduced form of he model, as given in Equaions (5) and (7), is usually esimaed imposing a priori resricions on he coefficiens. Quie frequenly, i is assumed ha he domesic and foreign coefficiens are idenical for domesic and foreign variables. However, in order o sar our analysis as unresricive as possible, we remove hese resricions. This mehod is generally suppored by he fac ha coefficiens ha are resriced o being equal for each variable ypically end o resul in biased coefficiens (Haynes and one, 1981). Wih regard o he opic of our invesigaion, removing hese resricions is also imporan, since he radi- 8 Wu and Hu (2009) emphasize he imporance of he Harrod-Balassa-amuelson effec when modeling deviaions from purchasing power pariy using an ETAR model. 10

13 ional moneary model assumes ha domesic and foreign asses are perfec subsiues for each oher. Consequenly, he porfolio effec of inervenions does no occur in such seings. By means of relaxing he symmery resricion regarding ineres raes, we herefore also relax he assumpion ha domesic and foreign bonds are perfecly inerchangeable. 9 Hence, he model we employ conains elemens of he porfolio balance approach of Branson (1977), which is preferable in work if risk premia are imporan. 2.3 Definiion of periods of massive foreign exchange marke inervenions in Japan Inervenions in he dollar-yen marke have occurred frequenly in he free-floaing era. An ineresing quesion is wheher ime periods wih excepional magniudes of inervenions can be idenified. In he following, we will describe six prominen cases. As official daa are only available from 1991, mos analyses up o his poin are based on changes in he official foreign reserves as a proxy for inervenions, and on he evaluaion of press aricles. Basically, boh indicaors can be applied o our opic because we are ineresed in periods of heavy inervenions. ince we do no necessarily need o specify he exac amouns in he coinegraion analysis, we make use of hese repored inervenion periods. We will accoun for he idenified periods in our coinegraion analysis by using inervenion dummies, which we can specify wihou his knowledge. Moreover, such a procedure is adequae because we are working wih monhly daa raher han daily daa. For he period 1993 o 2000, Galai e al. (2005) compare Reuers repors on inervenions wih he acual amouns of inervenions. ince heir resuls sugges ha he probabiliy ha inervenions had acually been underaken if hey were repored by Reuers was 0.84, hey conclude ha hese repors quie precisely mach inervenions acually underaken (Galai e al., 2005). As we will describe laer, we will in addiion rely on changes in he foreign exchange reserves. Figure 1 shows he nominal yen-dollar exchange rae in conjuncion wih he idenified periods of inervenions which we will describe in his secion. I can be seen ha he yen-dollar exchange rae has flucuaed remarkably, especially during he 1980s. -Figure 1 abou here- Afer he breakdown of Breon Woods in 1973, he yen sared o depreciae afer a shor spell of appreciaion as a resul of speculaive capial flowing ou of he counry. Consequenly, he moneary auhoriies in Japan began o sell dollars. The yen sabilized a around Goldberg (2000) argues ha a rejecion of he symmery resricion relaing o he ineres rae differenial is eiher linked o imperfec capial mobiliy or provides evidence in favor of he approach of imperfec knowledge over raional expecaion. 11

14 yen per dollar in Our invesigaion begins in 1976, when Japanese policy swiched in he direcion of moderaing he appreciaion of he yen, while in general limiing he amoun of inervenions (Takagi, 1991). This paern changed on differen occasions when he yen appreciaed heavily. This was especially rue in he period from Ocober 1977 unil he end of In November 1977, he amoun of inervenions came o around 32 percen of he rade volume in he foreign exchange marke. In March 1978 i had gone up o 44 percen (Komiya and uda, 1983; Takagi, 1991). From November 1978, he Bank of Japan joined he Fed, he Deusche Bundesbank and he wiss Naional Bank in a coordinaed aemp a selling yen o dampen is appreciaion. Japan s exchange rae policy changed again a he beginning of 1979, when he yen sared a spell of depreciaion. I follows ha he purpose of hese inervenions was o suppor he currency. These effors were paricularly inensified in he spring and auumn of 1979 (Takagi, 1991). However, accouning for he fac ha he amoun of inervenions slowed down afer he spring, we have decided o end our firs inervenion period (I1) in April 1979, wih he beginning specified as Ocober From 1981 onwards, he frequency of inervenions by he Japanese auhoriies shrank. This is an indicaion ha Japanese exchange rae policy was biased owards prevening yen appreciaion, as he auhoriies did lile o preven he massive yen depreciaion agains he dollar. However, he Plaza Agreemen held in New York on 22 epember 1985 iniiaed a series of coordinaed inervenions afer he paricipans saed ha exchange raes should beer reflec fundamenal economic condiions. The Group of Five reached an agreemen o conduc simulaneous sales up o 18 billion dollars (Obsfeld, 1990) in order o weaken he dollar. As a resul, he Fed suppored he BoJ in sabilizing he dollar-yen exchange rae. When he yen appreciaed o 200 yen/dollar, he aim of Japan s exchange rae policy became o sabilize he yen insead of allowing i o appreciae. Consequenly, from March 1986, he Japanese began purchasing dollars (Takagi, 1991). During May of he same year, he members of he Tokyo summi again commied hemselves o marke inervenions. The paricipans of he Louvre Accord also expressed he will o mainain nominal exchange raes near exising levels (Obsfeld, 1990). Large inervenions also occurred from immediaely afer he sock marke crash of Ocober 1987 hrough o December. In paricular, he period afer he Plaza Agreemen is ofen regarded as an example of successful inervenions in he foreign exchange marke. The credibiliy of he saemens, he degree of inernaional coordinaion and he fac ha marke paricipans indeed assessed he dollar as undervalued are 12

15 idenified as possible reasons for his. Accordingly, our second period (I2) runs from epember 1985 o unil January Beween April 1989 and April 1990 he Fed inervened in he dollar-yen marke wihou a suppor of he BoJ. This is he reason why we label his period Fed inervenion period (Ifed). 12 Alhough he yen experienced a period of appreciaion from 1991, i seems ha he Japanese did no inervene significanly o sop his developmen. For he res of he decade he yen remained remarkably srong, considering ha he Japanese economy suffered from deflaion and weak real economic growh (chnabl and Hillebrand, 2003). According o Frazscher (2008), oral inervenions favored a weaker yen afer i appreciaed o above 120 yen/dollar in While a sronger yen was briefly suppored in 1998, public saemens aferwards again expressed he view ha i should depreciae. As already menioned, daa on acual Japanese foreign inervenions have been published since April For he period up o 2004, Hoshikawa (2008) disinguishes beween a period of low frequency inervenions, from June 1995 o December 2002, and high frequency inervenions, from April 1991 o May 1995 and from January 2003 up o 2004 respecively. Io and Yabu (2007) argue ha he change in 1995, which corresponds o a srucural break in heir reacion funcion, is aribuable o he appoinmen of Dr. akakibara as direcor of he Inernaional Finance Bureau of he Minisry of Finance in June of ha year. Concerning he yen/dollar inervenions, hree periods of huge amouns of inervenions can be observed during he nineies and will be accouned for in he following. The hird period (I3) goes from May 1991 o Augus 1992 and is characerized by frequen inervenions of small magniude; while he fourh period (I4), from April 1993 unil January 1996, is also characerized by frequen inervenions of small magniude. 13 During his period, he Fed also inervened in he dollar-yen marke o some exen. The fifh period from January 1999 unil January 2000 (I5) is characerized by huge bu lowfrequency inervenions. Again, mos inervenions during he 1990s were aimed a lowering 10 The Fed also inervened in he dollar-yen marke in lae Nearly all of hese inervenions occurred in November This is he reason why we do no exend he second period o include he Fed inervenions. 11 During his period, inervenions were qualiaively differen. While he Plaza Agreemen was aimed a prevening he appreciaion of he U dollar, i.e. U dollar sales occurred, he Louvre Accord should sop he iniiaed counermovemen by U dollar purchases. ince we are no ineresed in he direcion of he inervenion, we rea boh periods as one period. 12 As will be seen in ecion 3.2, his period has no saisical significance. 13 ince he BoJ also inervened a he beginning of 1996, we decide o end his inervenion period in January

16 he appreciaion of he yen, which suggess ha Japan was seeking o weaken is currency (Morel and Teileche, 2004). Confroned wih deflaion, convenional moneary policy los is effeciveness afer he Cenral Bank cu he overnigh ineres rae o almos zero percen and he real ineres rae remained posiive. The exchange rae policy herefore became even more imporan in sopping he downward spiral of deflaion by simulaing demand over a lowering of he value of he yen. As a resul, massive dollar-supporing inervenions ook place beween 2001 and The Bank of Japan sold 35 rillion yen in exchange for dollars beween January 2003 and March 2004 (Faum and Huchinson, 2005). Accordingly, our sixh period runs from epember 2001 unil March 2004 (I6). ince ha ime he Japanese auhoriies have rarely inervened (Frazscher, 2008). Even when he yen sared o fall heavily agains he dollar in 2005, hey did lile o sop he rend by inervening in he currency marke. This is anoher hin ha he Japanese inervenion policy is indeed biased oward prevening he yen appreciaing. The Bank of Japan did, however, inervene in epember 2010 and again in March Neverheless, hese aciviies canno be seen as periods of massive inervenions, for which reason we omi hem. 3. Daa and empirical resuls of he coinegraed VAR approach 3.1 Daa We work wih monhly daa aken beween January 1976 and December 2007, alhough he BoJ did also inervene in laer periods. We have no accouned for he ime period hereafer because our main aim is o focus on periods of inervenions lasing several monhs, i.e. looking a he role of inervenions in a long-run perspecive. The BoJ (officially) inervened afer our chosen end only on wo days: 15 epember 2010 and 18 March Consequenly, hese inervenions do no mach our definiion. Furhermore, we decide o include only he period unil he financial crisis emerged, alhough he las inervenion period ended on 16 March The reason for his is ha in he course of he financial crisis remarkable swings 14 Boh daes are relaed o specific evens. The firs dae mus be seen in conjuncion wih he sovereign deb crisis in several EU member saes agains he background of dampening fligh-o-safey impacs on he exchange rae. In March 2011, he BoJ inervened afer a devasaing naural disaser. 14

17 in exchange raes could be observed (Frazscher, 2009a). ince hese developmens can poenially affec he esimaion of he long-run relaionship, we sop a he end of For money supply we op for he moneary aggregae M1. Real income is proxied by he indusrial producion index. In our model we include wo differen price measures. On he one hand we include he rae of inflaion ha is calculaed based on he consumer price index (CPI). On he oher, as suggesed by Wolff (1987), we make use of a relaive price measure which is he price raio of radable o non-radable goods. 16 Regarding he shor-erm ineres raes, we decide on using money marke raes wih a mauriy of hree monhs. As usual, exchange raes, money supply and real income are expressed in logarihms. All series are seasonally adjused and are aken from inernaional financial saisics from he Inernaional Moneary Fund. We sar our empirical invesigaion wih he applicaion of a baery of well-known uni roo ess o our daa. The resuls sugges ha all series should be reaed as non-saionary and inegraed of order one (I(1)). 17 Consequenly, we should apply coinegraion mehods o analyze he link beween exchange raes and fundamenals. 3.2 The coinegraed VAR approach: economeric mehodology In general, he concep of coinegraion refers o linear combinaions of non-saionary variables which resul in saionary equilibrium errors. As a resul, he linear combinaion(s) can be inerpreed as a long-run relaionship(s). There are differen ways of esing for coinegraion among a couple of variables. In he following, we apply he mulivariae es by Johansen (1988), which draws upon he following vecor auoregression represenaion (VAR): ΔX = αβ ' X 1 + Γ1ΔX Γk ΔX k 1 + ΦD + ε, = 1,...,T and k = 1,..., q (8) The non-saionary behavior is accouned for by a reduced rank resricion of he long-run marix Π, which can be fragmened ino wo marices α and β such ha Π = αβ '. The erm β gives he coefficiens of he variables for he r long-run relaion(s) while α conains he adjusmen coefficiens describing he reacion of each variable o disequilibria from he 15 Of course, we esimaed models wih longer periods and here are several hins of srucural breaks afer However, our fourh coinegraion vecor (see below) seems o be sable. The complee esimaion resuls are available upon reques. 16 The price of radable goods is proxied by he producer price index, while he consumer price index serves as a proxy for he baske of non-radables. 17 We conduced he ADF, he Phillips Peron and he KPPs es. The resuls are available upon reques. 15

18 r long-run relaions given by he r 1 vecor β ' X 1.The erm Γk ΔX k describes he shorrun dynamics of he model using p dependen variables (Juselius, 2006). The deerminisic componens are given by he ( p 1) vecor Φ D, while ε describes an independen and idenically disribued error erm. In he presen case, he expression μ includes he consan erm and ΦD dummies o accoun for ouliers in he residuals. In he case of persisen deviaions from he long-run equilibrium relaionship wih specific variables as he driving forces behind his developmen, he omission of hese forces would lead o biased coinegraion coefficiens. The reason behind his bias is sraighforward as we show in he following. The rue regression model should be ' ' = β X + Z + ε = β X + δ ' I + ε, (9) nf where ε is a whie noise error erm. The regression model from which he invesigaion sars is = β + ε. (10) '* X * The relaionship beween he omied variable and he he help of he familiar auxiliary regression as X variables can be described wih Z nf ' = δ ' I = λ X + η, (11) where η is a whie noise error erm. Insering Eq. (11) in Eq. (9) and rewriing his expression yields = ' ' ( β + λ ) + η + ε X. (12) Equaion (12) is he underlying model when Eq. (10) is esimaed. An esimaion based on Equaion (10), alhough Eq. (9) is rue, generaes he familiar omied variable bias. Consequenly, i holds ha and '* ' ' β = β + λ γ (13) ε = η + ε. (14) * 16

19 By neglecing he non-fundamenal variable he esimaed coinegraion vecor is biased and does no reflec he rue parameers. Wha is more, he biased esimaed coinegraion coefficiens also produce biased adjusmen coefficiens, because Π = α * β '* holds. In addiion, he finding of coinegraion iself is affeced by Equaion (14). 18 Coinegraion requires he error series η o be saionary. This is he case when he poenially omied variable is eiher saionary or linked o he non-saionary fundamenals in he long run, as can be seen from Equaion (11). Taken his as given, he omission of relevan deviaions from he arge value of he exchange rae produces a biased coinegraion vecor. Bearing hese argumens in mind, we can ake deviaions from he long-run relaionship ino accoun by rewriing he coinegraion space based on Eq. (8). The long-run Π X marix can be spli up as ~ ~ ' Π = αβ X ~, where X ~ also conains he dummies for he inervenion periods ha are considered significan according o exclusion ess laer on. We resric hese componens o lying in he coinegraion space. In he following, we will no focus on he shor-run view in our model, as our aim is o invesigae he long-run imporance of inervenions Prior analysis: deerminaion of he rank and exclusion ess We now proceed wih he deerminaion of he rank, ha is, deermining he number of saionary long-run relaionships. The inervenion periods idenified in ubsecion 2.3 ener as dummy variables when we specify hem as shifs in he coinegraion vecor. They are marked as I1, I2, I3, I4, I5 and I6, respecively. To idenify he number of coinegraing relaions r we rely on he race es developed by Johansen (1988). Owing o he large numbers of variables under observaion and o he fac ha he inclusion of exogenous shif dummies may aler he resuls of he race es, we have simulaed he asympoic disribuion by applying Mone Carlo simulaions. The simulaions were carried ou for random walks wih a lengh of 400 monhs and 2500 ieraions. The resuls are presened in Table 1. Table 1 abou here The hypohesis of a rank of four can clearly be rejeced a he 1% level, according o he es saisic, while a rank of five is marginally no rejeced a he 5% level. A rank of six canno be rejeced. ince he choice of rank is imporan and he resuls are no clear-cu, we have also considered recursive esimaes of he rank ess, which are available upon reques. Alogeh- 18 This is a very simplified explanaion of he problem in coinegraion regressions because we merely draw on a single equaion framework alhough we are using a mulivariae one. Our aim here is o highligh he general problem of omied variables in a coinegraion framework. 17

20 er, he resuls sugges ha a rank of 5 seems o be an adequae choice, alhough he resuls are inconclusive o some exen. For his reason, as a robusness check, we have esimaed our model addiionally for a rank of 6. The resuls, which are available upon reques, did no change he findings o a significan degree. We herefore proceed in he following by describing he resuls for a rank of 5. Turning o some diagnosics, Table 2 shows ha he hypohesis of no auocorrelaion canno be rejeced for he firs four lags a all convenional levels. Table 2 abou here In he nex sep, we run exclusion likelihood raio ess o analyze wheher he inervenion dummies should be included in our model (Juselius and MacDonald, 2004). 19 A join LRexclusion es for all inervenion periods rejecs he hypohesis ha all periods should be excluded from our model, wih a es saisic of a he 1% level. From his finding we proceed by esing for he significance of each inervenion period o achieve an adequae model srucure based on a general-o-specific approach. We presen he resuls in Table Table 3 abou here The findings sugges ha none of he inervenion periods should be excluded from our model a leas a he 10% level. However, for he las wo periods during he nineies (I4 and I5) he hypohesis of exclusion is only rejeced a he 10% level. This resul is no surprising, since he lieraure is sharply divided wih regard o he efficiency of inervenions during he nineies (arno and Taylor, 2001). When idenifying he coinegraing vecors as described in he nex secion, furher ess suggesed ha I4 gained significance afer I5 was omied from he coinegraing space. We herefore exclude I5 only for he final esimaions. A reesimaion of rank and auocorrelaion ess for our reduced model wihou I5 sill suggess ha a rank of five is he adequae choice wih he hypohesis of five long-run relaionships no being rejeced a he 5% level and auocorrelaion sill firmly rejeced. The resuls are presened in he hree columns on he righ-hand side in Table 1 and Table As menioned in ecion 2.3, we also considered inervenion periods of he Fed. According o he resuls of exclusion ess, he addiional period ha we labeled Fed inervenion period (from April 1989 unil March 1990) should no be included in he coinegraing space. For his reason, we omi his period. 20 The lag-lengh of he model is based on ess for auocorrelaion and he ARCH effec. The corresponding resuls for he ARCH effec are available upon reques. According o Rahbek e al. (2002), he resuls we gain in he following are sill robus under he remaining ARCH-effecs. Because of he high skewness and kurosis of some variables, dummies have been included in some cases. While excess kurosis does no inroduce a significan bias o he coinegraion esimaion resuls, he resuls are sensiive o excess skewness (Juselius, 2006; Juselius and MacDonald, 2004). Afer inroducing dummy variables ino he sysem, he rejecion of he assumpion of normaliy is due o excess kurosis, so ha our resuls are sill reliable. Jarque-Bera saisics for each variable and daes of he dummies inroduced are also available upon reques. 18

21 3.2.2 Hypohesis esing and idenificaion of he long-run srucure Afer we have deermined he rank, he Johansen approach provides he maximum likelihood esimaes of he unresriced coinegraing relaions. In order o achieve inerpreable economic relaionships for he long-run srucure, in cases of a rank greaer han one i is necessary o implemen resricions on β ha a leas jus idenify i because he coinegraion vecors are oherwise no unique. By having an economic model a hand, furher resricions can also be implemened so ha he model becomes over-idenified. The hypohesis ess are based on a likelihood raio procedure described in Johansen and Juselius (1992, 1994). Alhough we are primarily ineresed in he link beween he exchange rae and is fundamenals, we have o specify all five coinegraion vecors. In so doing, i is required ha we have furher reasonable economic relaions a hand. In resricing he exchange rae and he variables of he oher economies o zero we aim a specifying wo vecors o represen he domesic economies of Japan (relaion 1) and he Unied aes (relaion 2) respecively. The Japanese money supply urned ou o be insignifican so we removed i from relaion 1. The hird vecor links he exchange rae o prices. Consequenly, we originally included he raes of inflaion and he raio of radable o non-radable goods. However, only U.. inflaion and he Japanese price raio urned ou o be significan. To model he relaionship beween he exchange rae and he remaining fundamenals, we follow he moneary model as described and include ineres raes, money supply, income of boh counries and he exchange rae ino he fourh vecor. Resricions of he fifh vecor were guided by he significance of he coefficiens. The resuling relaions are presened in Table 4. Table 4 abou here The implied resricions are acceped wih a very high p-value of As he focus of our analysis is on he exchange rae, we do no exensively discuss he resuls of he firs and second relaions corresponding o he domesic economies of Japan and he Unied aes and he fifh relaion. The empirical findings for he exchange rae do appear raher promising. Money supply and ineres raes ener wih he correc sign in he fourh relaion for boh economies. This is also rue for U inflaion and he Japanese price raio in he hird relaion. However, boh U and Japanese income series urn ou o be significan bu ener wih he wrong sign in relaion four. This migh mean ha, owing o business cycle linkages, he effec of income on he exchange rae does no work via he money demand channel. This argumen seems o be plausible because direc price effecs do no ener he long-run relaionship. Ineresingly, he symmery resricion wih respec o money is also valid in he fourh 19

22 vecor. In addiion, he corresponding coefficiens can be resriced o having he same magniude as he coefficien for he nominal exchange, namely a value of one. This is a srong resul which relaes o he original version of he moneary model (Frankel, 1979). Applying zero resricions o he inervenion periods in he hird and/or fourh long-run relaionships resuls in a breakdown of he long-run relaionships, since he resuling resricions are rejeced. Hence, evidence of he moneary approach in he form described above is only provided if he inervenion periods are included. Nex, referring o he adjusmen coefficiens for he resriced model, we ackle he quesion of wheher he exchange rae adjuss o deviaions from he esablished long-run relaions. These coefficiens are more closely examined in Table 5. Table 5 abou here The resuls show ha he exchange rae adjuss o he fourh relaionship, which includes money, ineres raes and income, as well as o he hird long-run relaionship, which includes prices and inflaion. The resuls show ha he inervenion periods are imporan in he relaions referring o he exchange rae. For he hird relaion, all inervenion periods excep I1 gain significance for he exchange rae/price relaion, while he firs wo periods are imporan for he relaionship beween he exchange rae and he remaining fundamenals. This is consisen wih he view ha he exchange raes deviaed remarkably from heir fundamenal values during he 1980s. To some exen, we could argue ha inervenions during ha ime seem o have been jusified because heir inclusion in a ime series model suppors he finding of a heory-consisen relaionship beween he exchange rae and is fundamenals. In conras, all oher inervenion periods are no relevan o he fourh relaion, which means ha he long-run link beween exchange rae and is fundamenals can be found wihou aking addiional effecs ino accoun. Our resuls, are broadly robus wih respec o differen specificaions. As already described, we esimaed he model wih differen coinegraion ranks and also wih differen ends of he sample. I urns ou ha vecors hree and four are relaively robus regarding he coefficiens, he signs and he included dummies. However, he consiuion of he oher coinegraion vecors parly changes. Overall, he resuls of his secion sugges ha fundamenals play an imporan role in exchange rae movemens when inervenion periods are included. 20

23 3.2.3 Addiional adjusmen effecs in periods of inervenions ince we assume ha he Cenral Bank has knowledge of a misalignmen in he exchange when i inervenes, we mus conclude ha i has a fundamenal link beween exchange rae and fundamenals in mind. Insignifican dummy variables in our esimaed long-run relaionship could be an indicaion ha Cenral Bank inervenions have been successful. The reason for his is ha he Cenral Bank inervenes when here is a misalignmen, and when we canno find ex pos any misalignmens in long-run daa he inervenions migh be seen as being successful. However, if he dummies are significan, here is indeed an indicaion of a misalignmen ha could no be compleely removed. A clearer hin a successful inervenions should be ha he adjusmen owards he long-run equilibrium is enhanced during periods of inervenions. Consequenly, he adjusmen coefficien in Eq. (14) migh be greaer. In order o check wheher he adjusmen owards he long-run relaionship is greaer during periods of inervenions, we re-esimae he VECM in a slighly exended form. We keep all error correcion erms as obained (excep dummies) bu modify he exchange rae equaion of he VECM in he sense ha we allow for changes in he adjusmen parameer during each period of inervenions. These changes depend on he magniude of he inervenions in each inervenion period, i.e. we inerrelae each error correcion erm wih he volume of inervenions. From his poin of view, we are able o evaluae he addiional adjusmen effecs during each period ha sem from he srengh of he inervenion behavior. Hence, he exchange rae equaion in he VECM becomes ΔX = μ + α i ECTi, 1 + α i ECTi, 1Inm, 1 + Λ X i + Ξ Z i + D + i= 1 i= 1 m= 1,2,3,4,5, 6 i= 1 i= 0 while all oher equaions remain unchanged. The erm α i in Eq. (15) denoes he adjusmen coefficien in he i-h error correcion erm. The variables In m, 1 capure he inervenion volume during each m-h inervenion period. 21 The erms Ξ are marices of coefficiens regarding he lagged endogenous variables Λ and i ε (15) X and exogenous variables Dummy variables are capured by D and μ is an inercep. In conras o he esimaion of he long-run relaionship, we include he fifh inervenion period again. Concerning he modi- Z. i 21 ince we do no have inervenion volumes before 1991 we proxy hem wih he help of changes in foreign exchange reserves. We expec ha changes due o rue inervenions should be greaer han valuaion effecs. 21

24 fied exchange rae equaion, he resuls from he re-esimaed VECM are presened in Table 6, where we focus solely on he coinegraion vecors hree and four. Table 6 abou here In accordance wih he maximum likelihood esimaes, he dollar-yen exchange rae adjuss significanly o equilibrium errors of he hird and fourh error correcion erm. The fourh error correcion erm reflecs he long-run relaionship of he exchange rae wih is fundamenals (semming from he moneary model). Based upon convenional significance levels, i urns ou ha he adjusmen is faser in he second and fourh inervenion period as compared o he overall effec for boh he hird and he fourh erm. From hese resuls, i seems ha Cenral Bank inervenions have parly improved he adjusmen owards is equilibrium pah. ince we relae inervenion volumes o changes in he adjusmen coefficien, we are able o deliver evidence ha inervenions provide he reasons for our resuls. Ineresingly, his is rue for boh error correcion erms. Hence, inervenions increase he adjusmen speed owards boh long-run empirical relaionships beween exchange raes and fundamenals a he same ime. However, he effecs in boh periods differ wih respec o heir economic imporance. Alhough he effecs are saisically significan in boh periods, he adjusmen speed is only increased remarkably in he second inervenion period. From his poin of view, his can only be seen as an indicaion of successful inervenions in a long-run perspecive. Furhermore, during he firs, hird, fifh, and sixh inervenion periods no addiional effec can be idenified empirically. I is worh menioning ha he wo periods wih addiional effecs are associaed wih longer lasing inervenions (see, again, Table 1). In addiion, he second period is characerized by coordinaed inervenions, as described in ecion 2.3. This is consisen wih he lieraure, which saes ha coordinaed inervenions made known o he public are more likely o succeed (Beine e al., 2009; Frazscher, 2009b). Our resuls indicae ha inervenions have no been efficien in erms of reinforcing he selfadjusing behavior of he exchange rae in every period. This is in line wih furher approaches, we applied. We also experimened wih smooh ransiion models in which inervenions ener he ransiion variable. 22 However, he resuls give no clear evidence of he smooh ransiion ypes of non-lineariy wih monhly daa. The reason for his migh be ha hose periods are very heerogeneous, and smooh ransiion adjusmens aking inervenions ino accoun can only be measured using daily daa We esimaed a TR-VECM in which he ransiion funcion was very similar o Reiz and Taylor (2008). 23 ee, for example, Reiz and Taylor (2012) for he dollar-yen exchange rae. 22