International Review of Economics and Finance 49 (2017) 243254

Contents lists available at ScienceDirect

International Review of Economics and Finance

journal homepage: www.elsevier.com/locate/iref

The macroeconomic impact of foreign exchange intervention: An

empirical study of Thailand
MARK
Akihiro Kubo1
Graduate School of Economics, Osaka City University, Japan

AR TI CLE I NF O AB S T R A CT

JEL Classication: This paper focuses on empirically investigating the ecacy of foreign exchange intervention in
Numbers: F31 the Thai economy by simulation analyses. We nd that foreign reserves are determinants of
E52 exchange rate dynamics, whereas the uncovered interest parity condition does not hold. We also
Keywords: nd that foreign exchange intervention inuences the ination rate via the exchange rate,
Foreign exchange intervention although by a lesser degree, whereas such an intervention for an extended period is likely to incur
Monetary policy higher costs of the macro economy.
Small open economy model
Thailand

1. Introduction

An examination of the potential role of exchange rate management is important for emerging market countries. Following the
currency crises during the 1990s and 2000s, a number of central banks in emerging market countries abandoned the peg or xed
exchange rate systems and shifted to the more exible oating systems. At that time, most central banks instituted ination targeting
in their new monetary policy regimes. However, although the exchange rate generally moves in line with its economic fundamentals,
exchange rate movements of small open economies are occasionally extreme owing to exogenous causes and are thus inconsistent
with generally expected changes. Thus, many previous studies have explored whether the central banks managed the exchange rate
through foreign exchange intervention (e.g., Aizenman and Sun, 2012; Calvo & Reinhart, 2002; Pontines & Rajan, 2011).
In accordance with the impossible trinity, namely that countries cannot have free capital movement, managed exchange rates,
and independent monetary policy all at the same time, sterilized foreign exchange intervention has a signicant role under an
ination-targeting framework that has oating exchange rates. However, few empirical studies have far examined the macro-
economic impact of foreign exchange intervention under such a policy framework. This paper empirically investigates the eect of
foreign exchange intervention using the Thai macroeconomic data.
Thailand succeeded in bringing ination under control by adopting ination targeting with a managed-oating exchange rate
system. Under this framework, the Bank of Thailand (BOT) often controlled exchange rates and conducted sterilized intervention to
prevent disorderly movements. In recent years, however, import prices have become the driving force behind domestic ination, just
as in other emerging market countries. In addition, internal shocks such as political turbulence have often depressed investor
condence and generated substantial volatility in the country's international capital ows. It seems, therefore, that exchange rate
management plays an increasingly important role as a supplementary tool to ination targeting in Thailand (Chai-anant et al., 2008).
To empirically investigate the eect of a foreign exchange intervention shock mainly, this paper uses a semi-structural, small open
economy model of Berg et al. (2006). This model is also mostly identical to the model of Pongsaparn (2008), which is constructed at

E-mail address: kubo@econ.osaka-cu.ac.jp.

1
Address: 3-3-138 Sugimoto, Sumiyoshi-ku, Osaka 558-8585, Japan.

http://dx.doi.org/10.1016/j.iref.2017.02.001
Received 4 October 2016; Received in revised form 24 January 2017; Accepted 1 February 2017
Available online 09 February 2017
1059-0560/ 2017 Elsevier Inc. All rights reserved.
A. Kubo International Review of Economics and Finance 49 (2017) 243254

the BOT as a supplement to the BOT's traditional macroeconomic model and dynamic stochastic general equilibrium model,
especially for simulation (impulse response) analyses and forecasting.2 In fact, the model is tractable and versatile enough to be
employed by some studies for policy simulation analyses (e.g., Argov, Epstein, Karam, Laxton & Rose, 2007; Berg et al., 2006; Harjes
& Ricci, 2008). This model is superior to capture the relationship between major macroeconomic variables and their dynamics
similar to a vector autoregression (VAR) model. Although the model presented herein has no explicit microeconomic foundations, it
resembles the standard New Keynesian open economy models described, for example, by Justiniano and Preston (2010). It thus shifts
a purely empirical regression model much closer to a theoretical structure compared with a structural VAR model.
The remainder of this paper is organized as follows. Section 2 explains a semi-structural, small open economy model that we apply
to Thailand. Section 3 presents the Bayesian estimation methodology and the results. Section 4 discusses the dynamic responses of the
main macroeconomic variables to a foreign exchange intervention shock as well as to a conventional monetary policy shock. Section
5 concludes.

2. A semi-structural, small open economy model

This section presents the semi-structural, small open economy model developed by Berg et al. (2006). The model consists of two
sets of equations, the rst describing the Thai economy as a small open economy and the other adopting the US economy as a
representative for the rest of the world. Then, we include an oil price shock in a Phillips curve and a foreign reserve shock in the
exchange rate equation.

2.1. The Thai economy

The domestic output of the economy depends on its past and future output, real interest and exchange rates as well as on demand
in the rest of the world (i.e., the United States in this paper).

ygapt =1 ygapt 1+2 ygapt +13 (rt r *)+4 (zt z*)+5 ygapt f +ty , (1)

where ygapt denotes the output gap, rt the real interest rate, zt the real exchange rate, and * the equilibrium value of a variable.
Finally, ygapt f is an output gap in the US economy. Further, a residual captures other temporary exogenous factors such as scal policy
and other demand shocks.
Ination for headline consumer price index (CPI) depends on expected and lagged ination, the output gap, the exchange rate
gap, and the impact of oil prices, toil 3:

t =1 4t +4 +3 4t 1+ 2 ygapt +(1 13)(zt zt 1)+4 toil +5 toil

1+ t , (2)

where t is the annualized quarterly ination rate and 4t is the annual ination rate. Here, 4t+4 is the expected ination rate of the
four quarters ahead, while 4t1 captures the inertia. A residual captures other temporary exogenous supply shocks that are not
explicitly modeled.4
Since the BOT also focus on the core ination rate that excludes external shocks such as oil price movements,5 we include the core
ination (c, t ) equation given below:
c, t = c, 1 4c, t +4 + c, 3 4c, t 1 + c, 2 ygapt 1 + c, 4 (zt zt 1) + c, 5 ( 4t 1 4c, t 1) + c, t , (3)

where ( 4t 1 4c, t 1) is included for the possibility that workers and other price setters may try to partially keep their prices rising to
maintain pace with past movements in the headline CPI (Berg, et al., 2006, 21).
The exchange rate equation is determined by the uncovered interest parity (UIP). In addition, to investigate how a foreign
exchange intervention shock aects the macroeconomic variables, the exchange rate equation is modied in this paper as follows:

zt = zte+12 (rt rt f )/4 + 3 FRt +tz , (4)

6
where zte+1
= zt +1+(1 ) zt 1, r f is the real interest rate in the United States, and is the equilibrium risk premium. FRt is the
foreign reserves per nominal GDP. This represents the foreign exchange intervention, which aects the real exchange rate via the
nominal one. We assume that depreciation pressures of the domestic currency due to the purchase of foreign currency can dominate
the appreciation due to a risk premium drop as the foreign reserves increase. Although we are not able to identify the extent of this
intervention owing to limited data, we employ the foreign reserves reported in the balance of payments accounts as a proxy of the
foreign exchange intervention.7 Any other movement as exogenous exchange rate shocks would be captured in the residual.

2
Pongsaparn (2008) claims that the construction of this model does not aim to replace and substitute these both models. In addition, Kubo (2015) uses a small open
economy dynamic stochastic general equilibrium model for Thailand in order to investigate structural parameters mainly.
3
Ination is measured as annualized quarterly changes in percent; thus, t = 400[log (cpit )log (cpit1)]. 4t is the four-quarter change in the price index, namely
4t = (t +t 1+t 2+t 3)/4 .
4
Although the sum of the coecients on expected and past ination equals to one in the original model by Berg et al. (2006), in this study, we employ the free
parameter of the real depreciation following the BOT's specication by Chai-anant et al. (2008).
5
Indeed, core ination in Thailand is based on the CPI excluding raw food and energy.
6 e
zt +1 denotes rational expectations for the exchange rate.
7
Foreign reserves may be a poor proxy of intervention when interest income, valuation changes, or changes in the non-currency components of reserves are large.

244
A. Kubo International Review of Economics and Finance 49 (2017) 243254

We assume that the BOT sets the nominal short-term interest rate (it ), which responds to the output gap and the deviation of
ination from its target.8 Therefore, the equilibrium real interest rate as well as the expected ination according to the following
monetary policy rule is

it = 1 it 1 + (1 1 )[r * + c, t +1 + 2 ( 4c, t +4 *) + 3 ygapt ] + ti , (5)

where r * denotes the equilibrium real interest rate and * is the ination target four quarters ahead. The lagged interest rate features
interest rate smoothing.
An additional independent shock is considered in the model, namely foreign reserve behavior:
FRt =FRt 1+FR, t (6)

where the shock FA, t is iid with zero mean and standard deviations FA . However, this specication does not improve the model t to
the data.9 Thus, we employed the actual (raw) data as the exogenous variable.10

2.2. The US economy

The equations for the US economy, namely the output gap, ination, and the monetary policy rule, are similar to those presented
above, but without any global inuences:

ygapt f =1f ygapt 1

f
+2f ygapt +1
f
3f (rt f r f *)+tyf (7)

t f =1f 4tf+4 +(1 1f ) 4tf4 + 2f ygapt f +tf (8)

it f =1f it 1
f
+(1 1f )[r f *+t +1
f
+2f ( 4tf+4 f *)+3f ygapt f ]+tif (9)

3. Bayesian estimation

This section describes the construction of the data sets that are used for the estimation. It then presents the Bayesian estimation
methodology and the results.

3.1. Data

To estimate the model, we use ve key macroeconomic series for Thailand, in addition to oil prices and foreign reserves, and three
macroeconomic series for the United States.11 The series for Thailand are the real GDP gap, headline CPI ination rates, core CPI
ination rates, nominal interest rates (inter-bank overnight rates),12 and real bilateral exchange rates, while for the United States, we
use the real GDP gap, headline CPI ination rates, and nominal interest rates (Federal Funds rates). Since the model is written in gap
form, we construct, exogenously, the equilibrium values of real GDP, the real interest rate, and the real exchange rate by using the
HodrickPrescott lter. To capture the ination-targeting period, we select a sample period that runs from 2000Q2 to 2007Q2.
In Fig. 1, the top three panels report the year-on-year output growth, ination, and the short-term nominal interest rate for
Thailand. The bottom panel reports the foreign reserves per GDP and the bilateral exchange rate between Thailand and the United
States. We nd that there has so far been no deviation from the target range since the adoption of the ination-targeting regime and
that stable ination rates have been maintained with little sacrice in terms of output stability. The exchange rate also seems to have
moved relatively symmetrically with foreign reserves.13 This fact implies that the BOT's intervention policy can be characterized as
leaning against the wind.

3.2. Bayesian estimation methodology and result

We employ the Bayesian method based on Schorfheide (2000) to estimate the parameters of the model. This method is a bridge
between calibration and maximum likelihood via the specication of priors that allows for contributions from both the priors and

(footnote continued)
However, the purchases and sales of foreign reserves are the largest components in Thailand, as shown in the gures presented by Dominguez (2012).
8
This assumption is consistent with the approach taken by the BOT, which employs exible rather than strict ination targeting in order to seek a balance between
output and price stability (Kubo, 2008).
9
To examine whether the inclusion of foreign reserves as an independent shock in the exchange rate Eq. (4) improve the t of the model we re-estimate the model
under the restrictions FR = 0 in the equation, assessing the hypotheses FR = 0 against the alternatives FR > 0 by computing the posterior odds ratios. The marginal
data density is 2.5 larger on a log scale, which translates into a posterior odds ratio of almost zero (if using the same value, a posterior odds ratio of one would be
found). The posterior odds ratio (16.18) is above one as shown in Table 4 of Appendix A.
10
The posterior odds ratio (0.00) is below one as shown in Table 4 of Appendix A, which indicates a much larger improvement in t.
11
The data sources are the BOT's website and International Financial Statistics published monthly by the International Monetary Fund.
12
We use the market-expected rate rather than the constant policy rate.
13
Although the BOT seemed apprehensive of the appreciation consistently, it intervened strongly against rapid turnover to the depreciation that occurred in
2003Q1.

245
A. Kubo International Review of Economics and Finance 49 (2017) 243254

Fig. 1. Output growth, ination, interest rate, and exchange rates.

particular features of the data. Given a set of priors p(), the posterior density of the model parameters is given by

L (Y T | ) p ( )
p ( | Y T )=
L (Y T | ) p ( ) d

where L(YT | ) denotes the likelihood conditional on the observed data YT. The priors and likelihood function combination is
maximized in order to nd the posterior mode used as the initial value in a Random Walk Metropolis algorithm. By using the Markov
Chain Monte Carlo method, we characterize the posterior distribution of the parameters by drawing from the posterior density p(|
YT).
Table 1 reports the assumptions regarding the distribution of the priors of the parameters. The prior values for the mean and
standard deviations are guided by the following criteria. First, country-specic knowledge about the structural parameters or
estimates available in other studies is employed.14 Second, model parameters are chosen to reect some of the stylized facts of the

246
A. Kubo International Review of Economics and Finance 49 (2017) 243254

Table 1
Parameter estimation results, Thailand.

Parameter Prior Posterior

Mean Standard Error Distribution Mean 5% 95%

The Thai economy

Output gap
1 0.70 0.20 beta 0.476 0.248 0.754
2 0.10 0.03 beta 0.063 0.034 0.090
3 0.10 0.03 gamma 0.103 0.065 0.139
4 0.10 0.03 gamma 0.007 0.006 0.007
5 0.10 0.03 beta 0.119 0.058 0.187

Ination
1 0.30 0.06 gamma 0.364 0.270 0.455
2 0.25 0.06 gamma 0.266 0.195 0.347
3 0.30 0.06 gamma 0.387 0.292 0.477
4 0.01 0.01 gamma 0.015 0.000 0.029
5 0.01 0.01 gamma 0.003 0.000 0.008

Core ination
c,1 0.30 0.06 gamma 0.325 0.271 0.368
c,2 0.25 0.06 gamma 0.273 0.192 0.344
c,3 0.30 0.06 gamma 0.338 0.256 0.416
c,4 0.13 0.06 gamma 0.121 0.072 0.167
c,5 0.25 0.06 gamma 0.189 0.133 0.250

Exchange rate
2 0.50 0.50 gamma 0.020 0.000 0.045
3 0.50 0.50 gamma 0.790 0.000 1.536
0.50 0.20 beta 0.650 0.516 0.766

Monetary policy
1 0.50 0.10 beta 0.785 0.721 0.844
2 1.50 0.50 gamma 1.638 1.104 2.132
3 0.50 0.10 beta 0.405 0.275 0.511

The US economy

Output gap
1f 0.70 0.20 beta 0.817 0.733 0.904
2f 0.10 0.03 beta 0.104 0.061 0.142
3f 0.10 0.03 gamma 0.072 0.046 0.098

Ination
1f 0.20 0.06 gamma 0.429 0.252 0.540
2f 0.30 0.06 gamma 0.323 0.253 0.399

Monetary policy
1f 0.50 0.10 beta 0.806 0.751 0.857
2f 2.00 0.40 gamma 1.205 0.744 1.563
3f 0.50 0.10 beta 0.542 0.403 0.680

monetary transmission mechanism. Third, the parameters used in other countries for similar models are taken as the benchmark.
Based on these priors, we then estimate the parameters by using the MetropolisHastings algorithm with 200,000 replications. The
acceptance rate for each draw is approximately 30 percent and thus convergence is achieved.
Table 1 also presents the posterior mean and 90 percent condence interval for the parameters. Most posterior estimates pulled
away from the priors, which may suggest that the data were informative for the model. However, their 90% posterior probability
intervals are not in some cases. This may suggest the possibility of our model's misidentication.
The estimated parameter on the exchange rate term in the output gap equation is smaller than the prior mean. This result is
consistent with that of previous studies. Chai-anant et al. (2008) accounted for this through the domination of high-tech
manufacturing products in the export structure, rendering overall exports less sensitive to changes in exchange rates. The estimated
parameter for the interest rate dierentials term in the exchange rate equation is much smaller than expected. This nding is also
consistent with that of previous studies, implying the failure of the UIP condition and suggesting that carry trades play a role.15 On
the contrary, the estimated parameter for foreign reserves is larger than expected. This nding may imply that foreign exchange

14
For further details, see Chai-anant et al. (2008).
15
The failure of the UIP conditionat least in the short runis evident (Engle, 2000; Isard, 1995; McCallum, 1994). In the context of Thailand, Chai-anant et al.
(2008) and Pongsaparn (2007) both found that the UIP condition failed in the short-run. This may imply that it was due to the eect of capital controls (Jongwanich
et al., 2011).

247
A. Kubo International Review of Economics and Finance 49 (2017) 243254

intervention is a determinant of exchange rate dynamics in Thailand. Although the estimated values seem to be robust during the
post-crisis period, if the samples were extended to cover the global nancial shock period (200809), the results would structurally
change.
Subsequently, we consider that the BOT responds to ination, output, and exchange rate movements.16 The BOT may face a
dilemma between its ination target and exchange rate developments. The augmented monetary policy rule equation in the model is
modied as follows:
i
it =1 it 1+(1 1)[r *+c, t +1+ 2 ( 4c, t +4 *)+ 3 ygapt + 4 zt ]+ t , (10)
Table 2, however, shows a small parameter for the exchange rate term (4=0.084 ). This result implies that the BOT does not target
exchange rates. Thus, in the next simulation analysis, we assume that the BOT does not purposefully react to exchange rate
movements and instead intervenes in the foreign exchange market through sterilization to manipulate the exchange rateeven
though the eect of this intervention may be less. In other words, we strictly assume that monetary policy and sterilized intervention
cannot interact.

3.3. Other countries

We also estimate the parameters for other advanced and developing countries that employ ination targeting. Table 3 presents the
posterior means of the parameters in the exchange rate and monetary policy rule equations for Australia, Brazil, Canada, Chile, Israel,
New Zealand, the Philippines, South Africa, South Korea, and the UK.17 The estimated parameter for the interest rate dierentials
term in the exchange rate equation is smaller than expected for the UK and all developing countries. This implies that the UIP
condition does not hold in emerging market countries. By contrast, the estimates of foreign reserves are large in all developing
countries except Brazil and South Korea. This result implies that foreign exchange intervention plays the role of facilitating exchange
rate movements under ination targeting in emerging market countries. In addition, the estimates of the policy parameters are
similar in most instances, with a high degree of interest rate smoothing at an average value of 0.79.

4. Shock scenarios

In this section, we empirically test the eects of a monetary policy shock and the ecacy of foreign exchange intervention in
Thailand by using the model set out in Section 2. The rst part analyzes the initial conditions under which the BOT implements
conventional monetary policy, while the second part investigates the eects of a foreign exchange intervention shock, especially on
prices.

4.1. Conventional monetary policy

We examine how a monetary policy shock inuences the macroeconomic variables and explore how the BOT reacts to domestic
and external aggregate demand shocks. We also investigate whether the exchange rate acts as a channel for monetary policy
transmission.18
In Fig. 2, the responses of ination, the output gap, and the exchange rate to a temporary 100-basis-point hike in inter-bank
overnight rates are shown to be consistent with the evidence of monetary contraction presented by other studies of the monetary
transmission mechanism, such as Christiano et al. (1999). This nding implies that the BOT can successfully maintain the core
ination rate within its target range by regulating output. Specically, the core ination rate falls 0.076 percent below the target
during the rst quarter of the second year, while the decline is longer for ination than it is for output, as many monetary policy
transmission channels to ination pass through the expenditure and output gaps. To counter this fall in prices and slowdown in
output, the BOT lowers interest rates, which fall slightly below the control level approximately two years after the shock. Aggregate
demand reacts upward to the baseline in the fourth year. Moreover, the exchange rate appreciates because of a rise in interest rates
(through arbitrage asset pricing and modied UIP conditions). It thus seems that exchange rate appreciation can lead to a decrease in
import prices.

4.2. Foreign exchange intervention

We next use simulation measures based on the important assumption that the BOT can fully manage exchange rates through
sterilized intervention to investigate the likely impact on the economy if we were to adopt foreign exchange intervention. To compare
the same exchange rate eects of interest rate and foreign intervention shocks on macroeconomic variables, we engineer the

16
Cspedes et al. (2004), Garcia et al. (2011), and Morn and Winkelried (2005) suggested that including the exchange rate in the reaction function is benecial in
very open economies, although the optimal weight is small.
17
Source: International Financial Statistics. The sample period runs from 2000Q1 to 2007Q2, with the exception of the Philippines and South Africa, which starts
from 2002Q1.
18
Conventionally, the role of exchange rates under a oating exchange rate regime seems to be like a channel in the monetary policy transmission mechanism. The
other important role of exchange rates is as a shock absorber. According to Chai-anant et al. (2008), because the exchange rate may not act as a shock absorber to an
ination shock in Thailand, it can only be used as a supplement to conventional monetary policy under ination targeting.

248
A. Kubo International Review of Economics and Finance 49 (2017) 243254

Table 2
Parameter estimation results, Thailand.

Parameter Prior Posterior

Mean Standard Error Distribution Mean 5% 95%

Exchange rate
2 0.50 0.50 gamma 0.037 0.000 0.084
3 0.50 0.50 gamma 0.712 0.000 1.358

Monetary policy
1 0.50 0.10 beta 0.752 0.684 0.818
2 1.50 0.50 gamma 1.070 0.770 1.372
3 0.25 0.10 beta 0.222 0.114 0.335
4 0.25 0.10 beta 0.084 0.024 0.139

Table 3
Posterior means, other countries.

Country Exchange rate Monetary policy

2 3 1 2 3

Advanced countries
Australia 0.465 0.493 0.857 1.300 0.350
Canada 0.914 0.560 0.750 1.132 0.344
New Zealand 0.491 0.456 0.794 1.748 0.327
UK 0.139 0.397 0.890 1.232 0.326

Developing countries
Brazil 0.104 0.493 0.723 2.118 0.463
Chile 0.009 0.849 0.490 0.757 0.478
Israel 0.026 0.565 0.851 1.901 0.183
Philippines 0.005 0.848 0.864 0.784 0.169
South Africa 0.357 0.604 0.861 1.625 0.276
South Korea 0.010 0.488 0.775 0.344 0.513

magnitude of an intervention shock to the level that yields a comparable impact on the exchange rate to a 100-basis-point interest
rate shock.
In Fig. 3, we observe how a negative foreign exchange intervention shock that causes an appreciation in the exchange rate
propagates through the economic system. The exchange rate immediately appreciates on impact and then depreciates back to the
control level. This nding is consistent with most theoretical models, suggesting that selling foreign currency and purchasing
domestic currency strengthens the latter.19 Prices tend to decrease slightly before returning to the initial level in the subsequent
period. Specically, an intervention shock initially lowers the core ination rate by 0.012 percent and reduces the headline ination
rate by approximately 0.006 percent below the control level. However, monetary policy and output responses are mostly invisible for
two reasons: (i) the monetary policy equation excludes the exchange rate and (ii) the estimated exchange rate parameter in the output
gap equation is small. In addition, foreign exchange intervention seems not to signal future changes in monetary policy stance.20
Given the same maximum extent of deation for the core CPI, we nd that the eect of an intervention shock on headline ination
is larger but shorter than that of an interest rate shock (Fig. 4). This result may not be surprising, and it could occur because an
appreciation in the exchange rate directly lowers import prices, such as oil-related prices in terms of headline ination. When
international commodity prices tend to be higher, as they have been recently, foreign exchange intervention seems to be more
eective than conventional monetary policy in curbing headline ination. This nding implies that such an intervention supplements
conventional monetary policy in a small open ination-targeting country.
Further, we investigate the macroeconomic impact of two- and four-quarter intervention shocks. To discuss the duration of
exchange rate manipulation, we compare the intervention results for longer durations with the previous result obtained for a
temporary one-quarter intervention shock. Fig. 5 shows that long-term intervention induces lower output growth, although small.
Specically, when the duration is four quarters, output drops to its lowest point in the second quarter before continuing to be volatile
in the long run. In addition, ination rates fall initially and swiftly rise thereafter, while interest rates gradually rise to respond to the
positive inationary pressure. This nding suggests that intervention for an extended period is likely to incur higher costs, which is
consistent with the fact that the BOT applies temporary foreign exchange intervention only in specic circumstances.

19
Indeed, the BOT intervenes in the foreign exchange market mainly through outright spot transactions of selling or buying Thai baht against the US dollar.
20
See, for example, Dominguez and Frankel (1993), Kaminsky and Lewis (1996), Kim (2003), and Sarno and Taylor (2001) for more theoretical details.

249
A. Kubo International Review of Economics and Finance 49 (2017) 243254

Output gap (%pt) Headline inflation (%pt)

.04 .02

.00 .00

-.04 -.02

-.08 -.04

-.12 -.06

-.16 -.08

-.20 -.10
1 5 9 13 17 1 5 9 13 17

Core inflation (%pt) Interest rate (%pt)

.02 1.2

1.0
.00
0.8
-.02 0.6

-.04 0.4

0.2
-.06
0.0

-.08 -0.2
1 5 9 13 17 1 5 9 13 17

Exchange rate (%)

.01

.00

-.01

-.02

-.03

-.04

-.05

-.06
1 5 9 13 17

Fig. 2. A conventional monetary policy shock.

5. Conclusion

This paper used the semi-structural, small open economy model to investigate the eect of the BOT's policy of foreign exchange
intervention under ination targeting and arrived at four key ndings. First, foreign reserves are determinants of exchange rate
dynamics,21 while the UIP condition does not hold. Second, while foreign exchange intervention seems to aect the exchange rate,
the eect of such an intervention on output and monetary policy is small. Third, such an intervention has stronger eects on headline
ination than conventional monetary policy. Finally, such an intervention for an extended period is likely to incur higher costs of the
macro economy.

21
To gauge the signicance of a foreign reserve shock on the exchange rate and compute the variance decompositions, we reestimate the model including Eq. (6).
The impact of a foreign reserve shock on the exchange rate is 17.37%, which is small compared with exchange rate uctuations themselves (82.63%), as shown in
Table 5 of Appendix A.

250
A. Kubo International Review of Economics and Finance 49 (2017) 243254

Output gap (%pt) Headline inflation (%pt)

.04 .02

.00 .00

-.04 -.02

-.08 -.04

-.12 -.06

-.16 -.08

-.20 -.10
1 5 9 13 17 1 5 9 13 17

Intervention Conventional MP Intervention Conventional MP

Core inflation (%pt) Interest rate (%pt)

.01 1.2
.00 1.0
-.01
0.8
-.02
-.03 0.6
-.04 0.4
-.05
0.2
-.06
-.07 0.0

-.08 -0.2
1 5 9 13 17 1 5 9 13 17

Intervention Conventional MP Intervention Conventional MP

Exchange rate (%)

.01

.00

-.01

-.02

-.03

-.04

-.05

-.06
1 5 9 13 17

Intervention Conventional MP

Fig. 3. A foreign exchange intervention shock (the same maximum extent of currency appreciation to an interest rate shock).

This investigation enables us to draw certain policy implications. In Thailand, while core ination rates have been maintained
within the target range, headline ination has become increasingly sensitive to external shocks, such as the recent high international
commodity prices. However, society expects both the headline and the core ination rates to be stable to provide an environment
conducive to economic growth. Thus, it seems as though intervention is necessary in the foreign exchange market to mitigate the
pressures of headline ination. In addition, we often consider the exchange rate to be a random asset-pricing mechanism that may be
increasingly dicult to successfully moderate the processes of foreign exchange intervention.
The empirical results in this study are subject to an important caveat. The variable of foreign reserves as a percentage of GDP

251
A. Kubo International Review of Economics and Finance 49 (2017) 243254

Output gap (%pt) Headline inflation (%pt)

.04 .08

.00 .04

-.04 .00

-.08 -.04

-.12 -.08

-.16 -.12

-.20 -.16
1 5 9 13 17 1 5 9 13 17

Intervention Conventional MP Intervention Conventional MP

Core inflation (%pt) Interest rate (%pt)

.04 1.2

.02 1.0

0.8
.00
0.6
-.02
0.4
-.04
0.2
-.06 0.0

-.08 -0.2
1 5 9 13 17 1 5 9 13 17

Intervention Conventional MP Intervention Conventional MP

Exchange rate (%)

.1
.0
-.1
-.2
-.3
-.4
-.5
-.6
-.7
-.8
1 5 9 13 17

Intervention Conventional MP

Fig. 4. A foreign exchange intervention shock (the same maximum extent of core ination to an interest rate shock).

positively depends on the exchange rate. This may generate positive estimated parameters. There is also an important extension of
this study that could be pursued in future studies. Foreign reserve behavior could be endogenous in the specication of the model to
examine how much the central bank intervenes in the foreign exchange market to various shocks.

Acknowledgements

I would like to thank an anonymous referee for detailed comments. I am also grateful to the participants at the Conference of the

252
A. Kubo International Review of Economics and Finance 49 (2017) 243254

Output gap (%pt) Headline inflation (%pt)

.0010 .02

.0005 .01
.0000
.00
-.0005
-.01
-.0010
-.02
-.0015

-.0020 -.03

-.0025 -.04
1 5 9 13 17 1 5 9 13 17

Duration = 1 Duration = 2 Duration = 3 Duration = 1 Duration = 2 Duration = 3

Core inflation (%pt) Interest rate (%pt)

.010 .010

.005 .008

.000 .006

-.005 .004

-.010 .002

-.015 .000

-.020 -.002
1 5 9 13 17 1 5 9 13 17

Duration = 1 Duration = 2 Duration = 3 Duration = 1 Duration = 2 Duration = 3

Exchange rate (%)

.00

-.04

-.08

-.12

-.16

-.20
1 5 9 13 17

Duration = 1 Duration = 2 Duration = 3

Fig. 5. Long-term intervention shocks.

American Committee for Asian Economic Studies and the Japanese Economic Association Spring Meeting, Nasha Ananchotikul,
Atsushi Fukumi, Kaku Furuya, Takamitsu Kurita, Yoichi Matsubayashi, Tetsuya Nakajima, Eiji Ogawa, Runchana Pongsaparn for
their helpful and useful comments. I gratefully acknowledge nancial support from the Japan Society for the Promotion of Science,
Grants-in-Aid for Young Scientists (B23730282).

Appendix A. Supplementary material

Supplementary data associated with this article can be found in the online version at http://dx.doi.org/10.1016/j.iref.2017.02.001.

253
A. Kubo International Review of Economics and Finance 49 (2017) 243254

References

Aizenman, J., & Sun, Y. (2012). The nancial crisis and sizable international reserves depletion: From fear of oating to the fear of losing international reserves'?
International Review of Economics and Finance, 24(C), 250269.
Argov, E., Epstein, N., Karam, P., Laxton D., and Rose, D. (2007). Endogenous monetary policy credibility in a small macro model of Israel. International Monetary
Fund Working Paper, 07/207.
Berg, A., Karam, P., and Laxton, D. (2006). Practical model-based monetary policy analysisa how-to guide. International Monetary Fund Working Paper, 06/81.
Calvo, G. A., & Reinhart, C. M. (2002). Fear of oating. The Quarterly Journal of Economics, 117(2), 379408.
Cspedes, L., Chang, R., & Velasco, A. (2004). Balance sheets and exchange rate policy. American Economic Review, 94(4), 11831193.
Chai-anant, C., Pongsaparn, R., and Tansuwanarat, K. (2008). Roles of exchange rate in monetary policy under ination targeting: A case study for Thailand. Bank of
Thailand Discussion Paper, 09/2008.
Christiano, L. J., Eichenbaum, M., & Evans, C. L. (1999). Monetary policy shocks: What have we learned and to what end? In J. B. Taylor, & M. Woodford (Vol. Eds.),
Handbook of macroeconomics, 1A.Amsterdam: North-Holland.
Dominguez, K. M. E., & Frankel, J. A. (1993). Does foreign-exchange intervention matter? The portfolio eect. American Economic Review, 83(5), 13561369.
Dominguez, K. M. E. (2012). Foreign reserve management during the global nancial crisis. Journal of International Money and Finance, 31(8), 20172037.
Engle, R. F. (2000). The econometrics of ultra-high frequency data. Econometrica, 68(1), 122.
Garcia, C. J., Restrepo, J. E., & Roger, S. (2011). How much should ination targeters care about the exchange rate? Journal of International Money and Finance, 30(7),
15901617.
Harjes, T. and Ricci, L.A. (2008). A Bayesian-estimated model of ination targeting in South Africa. International Monetary Fund Working Paper, 08/48.
Isard, P. (1995). Exchange rate economics New York: Cambridge University Press.
Jongwanich, J., Gochoco-Bautista, M.S., and Lee, J. (2011). When are capital controls eective? Evidence from Malaysia and Thailand. Asian Development Bank
Economics Working Paper Series 251.
Justiniano, A., & Preston, B. (2010). Can structural small open-economy models account for the inuence of foreign disturbances? Journal of International Economics,
81(1), 6174.
Kaminsky, G. L., & Lewis, K. K. (1996). Does foreign exchange intervention signal future monetary policy? Journal of Monetary Economics, 37(23), 285312.
Kim, S. (2003). Monetary policy, foreign exchange intervention, and the exchange rate in a unifying framework. Journal of International Economics, 60(2), 355386.
Kubo, A. (2008). Macroeconomic impact of monetary policy shocks: Evidence from recent experience in Thailand. Journal of Asian Economics, 19(1), 8391.
Kubo, A. (2015). Did central banks respond to currency depreciation during the global nancial crisis? Mimeo.
McCallum, B. (1994). A reconsideration of the uncovered interest parity condition. Journal of Monetary Economics, 33(1), 105132.
Morn, E., & Winkelried, D. (2005). Monetary policy rules for nancially vulnerable economies. Journal of Development Economics, 76(1), 2551.
Pongsaparn, R. (2007). Ination targeting in a small open economy: A challenge to monetary theory. Bank of Thailand Discussion Paper, 02/2007.
Pongsaparn, R. (2008). A small semi-structural model for Thailand: Construction and applications. Mimeo.
Pontines, V., & Rajan, R. S. (2011). Foreign exchange market intervention and reserve accumulation in emerging Asia: Is there evidence of fear of appreciation?
Economics Letters, 111(3), 252255.
Sarno, L., & Taylor, M. P. (2001). Ocial intervention in the foreign exchange market: Is it eective and, if so, how does it work? Journal of Economic Literature, 39(3),
839868.
Schorfheide, F. (2000). Loss function-based evaluation of DSGE models. Journal of Applied Econometrics, 15(6), 645670.

254