Exchange Rate Policy and Shocks to Asset Markets: The Case of Taiwan in the 1980s

Abstract

This paper uses a simple theoretical model to show how the credibility of unsterilized intervention policy may affect the pattern of adjustment in the exchange rate, velocity, and asset prices. When the outcome of unsterilized intervention is credible, any degree of exchange rate stability can be achieved at the cost of a sufficiently large, one-time change in the money supply. When the outcome of intervention is not credible, intervention can lead to persistent, and possibly accelerating, changes in exchange rates, the money supply, velocity, and asset prices. Under certain conditions, intervention may even amplify the cumulative change in the exchange rate, rather than reduce it. The model is used to interpret Taiwan`s experience with unsterilized exchange rate intervention in the second half of the 1980s.