Central Bank Policy Instruments and Exchange Market Pressure

Download or read book Central Bank Policy Instruments and Exchange Market Pressure written by Lakmini Wickremeratne and published by . This book was released on 2023 with total page 0 pages. Available in PDF, EPUB and Kindle. Book excerpt: Emerging economies have been facing increasingly volatile exchange rates due to recent developments in financial markets. Such volatility is concerning for policy makers as exchange market pressure could potentially destabilize an otherwise stable economy. This paper models the determinants of the exchange market pressure in Sri Lanka using monthly data from January 2003 to March 2019 and seeks to identify whether policy instruments of the Central Bank have a significant effect on reducing the pressure on the exchange rate. The study uses an Unrestricted Vector Auto Regression Model to identify the short term influence of the interest rate differential and foreign exchange market intervention on exchange market pressure and finds limited impact of these policy instruments. It then goes on to model a two state Markov Regime Switching Model which reveals that the interest rate differential is useful in deterring exchange market pressure during times of turbulence in the foreign exchange market. The findings reveal that intervention in the foreign exchange market, while signaling the monetary authority's commitment to defend the exchange rate in the short term, might lead to expectations for further depreciation in the medium term; resulting in a self-fulfilling prophecy.