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The Impact of Central Bank's intervention in the foreign exchange market on the Exchange Rate: The case of Zambia (1995-2008)

Mwansa, Katwamba (2009): The Impact of Central Bank's intervention in the foreign exchange market on the Exchange Rate: The case of Zambia (1995-2008).

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Abstract

The central bank of Zambia called Bank of Zambia (BOZ) has, like many other central banks in both developing and developed economies, been from time to time intervening in the foreign exchange market by either purchasing or selling foreign exchange (mainly United States of America Dollars) to the market. Central banks have given a myriad of reasons for this particular behaviour. Chief among these and which is the focus of this paper is to smooth volatility or reverse a trend of the domestic currency in this case the kwacha. Despite central banks’ intervention activities in the foreign exchange markets, literature on the efficacy of these interventions in terms of impacting domestic currencies has remained controversial. While some strands of literature seem to suggest that such intervention has an impact on the currencies some literature disagrees.

Early studies done in the 1980s suggest that intervention operations do not affect the exchange rate and if they do this effect is very small and only in the short run. More recent studies however, have found evidence of the effect on both the level and volatility of exchange rates. Further, recent studies focused on emerging market and developing countries have found strong evidence of the effect of central banks’ intervention operations in the foreign exchange market on exchange rates.

This paper therefore examines the effect of the BOZ’s foreign currency market interventions on the level and volatility of the kwacha/ USD exchange rate between 1995 and 2008. In order to study the impact of interventions on the kwacha, the paper uses monthly data (both sales and purchases) on foreign exchange intervention and employs the GARCH (1, 1) and Exponential GARCH frameworks to model volatility. The results from GARCH model suggest that sales of foreign exchange in this case the $ causes the exchange rate to appreciate while purchases of the $ cause the exchange rate to depreciate. As for the impact on volatility, the GARCH (1, 1) model reveals that BOZ interventions increase volatility.

Empirical results from the EGARCH model on the other hand suggest that both sales and purchases of $ cause the exchange rate to appreciate. The results on the impact of intervention on volatility are mixed though generally intervention appears to be increasing volatility.

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