Implementing Sterilized Intervention Under An Inflation Targeting Regime: An ARCH Model Approach

Abstract

This senior thesis attempts to analyze the effectiveness of sterilized intervention on moderating exchange rate volatility and levels under non-inflation targeting and inflation targeting regimes in emerging market economies. We will use ARCH models to estimate this relationship separately over a non-inflation targeting regime in Mexico (June 23 1996-Dec. 29 2000), a contiguous inflation targeting regime in Mexico (Jan. 02 2001-Jan. 02 2015), and a non-inflation targeting regime in Uruguay (Dec. 26 2005-Aug. 13 2007) using data from central bank reports on intervention size and exchange rate data from Global Insight. Further, in an effort to compare the parameters estimated under the non-inflation targeting, and inflation targeting regimes, I will apply parameter stability tests at a known change point to compare the contiguous non-inflation targeting and inflation targeting periods in Mexico. This method is thus a test of pure structural change between the model estimated in Mexico’s non-inflation targeting and inflation targeting regimes. While this thesis does find that implementing sterilized interventions under an inflation targeting regime yields significantly different results than implementing sterilized intervention under a non-inflation targeting regime, the results do not indicate the sterilized intervention is more effective under a two target monetary policy framework as some of the literature suggests. Principally, this thesis finds that implementing sterilized intervention under an inflation targeting regime can increase exchange rate volatility. Additionally, our results weakly suggest that sterilized intervention under an inflation targeting regime is more successful at affecting the level of the exchange rate in the intended direction than under a non-inflation targeting regime.