The Forward Exchange Market, Speculation, and Exchange Market Intervention

Abstract

This paper examines two issues. The first is the role of speculation in stabilizing the economy against stochastic disturbances. Increased speculation (i) stabilizes domestic income against disturbances in the domestic bond market and forward exchange market; (ii) exacerbates the effect of foreign disturbances; and (iii) may dampen or augment the effect of money market and output supply disturbances. The second issue is the role of the forward market in stabilization policy. Forward market intervention does not provide monetary authorities additional leverage in stabilizing income beyond unsterilized spot market intervention. Intervention rules based on reactions to both the forward and the spot exchange rates, however, can outperform intervention policies responding to the spot rate alone, regardless of the market in which intervention occurs.

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