Implicit bands in the yen/dollar exchange rate

Abstract

This article attempts to identify implicit exchange rate regimes for the yen/dollar exchange rate. To that end, we apply a sequential procedure that considers both the dynamics of exchange rates and central bank interventions to data covering the period from 1971 to 2003. Our results suggest that implicit bands existed in two subperiods: April–December 1980 and March–October 1987, the latter coinciding with the Louvre Accord. Furthermore, the study of the credibility of such implicit bands indicates the high degree of confidence attributed by economic agents to the evolution of the yen/dollar exchange rate within the detected implicit band rate, thus lending further support to the relevance of such implicit bands.

Acknowledgements

The authors wish to thank two anonymous referees and Mark Taylor for helpful comments and suggestions on a previous draft of this article, substantially improving the content and quality of the article. We are also in debt to Christopher Neely (Federal Reserve Bank of St. Louis) for kindly providing the data set on official interventions used in this article. Financial support from the Spanish Ministry of Science and Technology (SEJ2005-09094/ECON) is also gratefully acknowledged. The views expressed here are those of the authors and not necessarily those of the institutions with which they are affiliated.

Notes

¹ See Coudert and Dubert (2004) for a survey of studies on implicit exchange rate regimes. Reinhart and Rogoff (2004) examine the relevance of the exchange rate regime classifications for empirical macroeconomics.

² For example, Ito and Yabu (2004) and Frenkel et al. (2004) estimate the Japanese monetary authorities’ reaction function.

³ We are grateful to an anonymous referee for suggesting this sensitivity analysis using deviations from PPP.

⁴ We also explore the possibility of much wider implicit bands, but they were not consistent with the data. As a matter of fact, although the maximum deviation of the observed exchange rate variation from the theoretical exchange rate variation derived from relative PPP (i.e. the inflation differential between Japan and USA) was 10.27% during the January 1971 to December 2007 period, the average deviation was 2.12% and the median 1.68%, giving further support to the hypothesis of implicit fluctuation bands of ±2%.

⁵ Jeon and Lee (2002) show that within-country market efficiency appears to have become stronger in the post-Plaza agreement period than before and have not been affected by the major foreign exchange policy co-ordinations.

⁶ Neely (2000) has shown that central bank interventions and reserve changes may be loosely related. Therefore, the use of reserves instead of interventions may lead to inadequate classifications.

⁷ We study the incidence of interventions at the exchange rate level. See Dominguez (1993, 2003) for a survey of the literature analysing the effect of intervention on the volatility of exchange rates. Wan and Kao (2008) find that foreign exchange interventions by the Japanese authorities were effective not only in altering the exchange rate level, but also in volatility reduction. On the other hand, results in Chen and Huang (2007) suggest no significant difference between the effectiveness of joint intervention and independent intervention on the yen/US dollar exchange rate during the 15 August 1996–6 January 1999 period. Finally, Ramchander and Sant (2002) show that FED intervention is associated with negative changes in the US$/volatility during the 1985 to 1993 period as a whole, and specifically during the 1 January 1985 to 21 February 1987 Plaza period and the 21 February 1987 to 31 December 1989 Louvre period.

⁸ We adopt this approach because standard time-series techniques may not be appropriate when dealing with the study of foreign market intervention and the associated behaviour of exchange rates. Exchange rates are highly volatile and interventions are usually sporadic (Fatum and Hutchison, 2003, 2005). In contrast, Frenkel et al. (2004) estimate a reaction function for sterilized interventions by the Japanese monetary authorities and find major interventions after 1995 in reaction to the previous exchange rate trend.

⁹ To calculate these frequencies we only consider the number of days in a given month in which the monetary authority intervened.

¹⁰ In order to assess the robustness of results, we additionally apply the Fisher's Exact Test. This test of independence (for 2 × 2 tables) is used when the members of two independent groups can fall into one of two mutually-exclusive categories. In our case, each day in a given month can fall into one of two categorical variables: the sign of the exchange rate trend and the sign of the intervention. The former may give two levels (appreciation or depreciation of the yen) while the latter indicates the purchase or sale of dollars. The results confirm those obtained from the Pesaran–Timmermann test. Again, the results for Japanese interventions are less informative and the independence hypothesis could not be rejected for the whole sample period.

¹¹ Based on an event study methodology, Fatum and Hutchison (2005) analyse the yen/dollar exchange rate and find evidence that intervention affects the rate in the short term. Taylor (2004) also obtains evidence supporting the view that interventions increase the probability of stability (only when the exchange rate is misaligned) in a Markov-switching model.

¹² It should be noted that, despite the aggressive actions taken by the BOJ to contain inflation and the importance of imported crude oil to Japan, the effect of the oil price on output appears to be moderate (Hetzel, 1999), with Japan being the only major industrial country to avoid recession (Cargill et al., 1997).

¹³ Schwartz (2000) argues that the strong yen did not weaken as a result of interventions and sterilization of dollar purchasing. However, Pinto de Andrade and Divino (2005) attribute a major role to exchange rates in accounting for cyclical patterns of the interest rate. In this sense, the BOJ appears to have attempted to stabilize the exchange rate via interest rates.

¹⁴ This band has been chosen as an exploratory proposal and hence the results must be interpreted in relative terms, i.e. as a comparison of the different subperiods during the period studied, in this case 1980.

¹⁵ The weights used by Edison (2003) incorporate the SDs of the exchange rate and the reserves, while Kaminsky et al. (1998) introduce the SDs of the variations of the exchange rate and the reserves. Furthermore, in the first paper the critical level to consider a currency crisis is the mean plus 1.5 times the SD of the index, while in the second one is the mean plus three times the SD of the index.