A friction model of daily Bundesbank and Federal Reserve intervention

This paper takes a novel approach to derive a central bank intervention reaction function. A GARCH model for exchange rates is amended to allow interventions to have an effect on both the mean and the variance of exchange rate returns. An intervention reaction function is obtained by combining the model with a loss function for the central bank. Estimation results for the implied friction model reproduce the familiar 'leaning against the wind' policy by the Bundesbank and the Federal Reserve. Furthermore, the central banks appear to have reacted to increases in the conditional variance of daily DM/$-returns.