Introduction
Exchange rate intervention refers to actions taken by a central bank to influence the value of its currency in the foreign exchange market. This can involve buying or selling foreign currency reserves, adjusting interest rates, or implementing capital controls. The effectiveness of these interventions in achieving external balance, which refers to the equilibrium between a country's current account and its capital account, is a subject of ongoing debate among economists. External balance is important for long-term economic stability and growth, as it indicates a sustainable level of borrowing and lending with the rest of the world.

Methods of Exchange Rate Intervention
Central banks employ a variety of methods to intervene in the foreign exchange market:

⭐Direct intervention: This involves the central bank directly buying or selling foreign currency reserves in the market. Buying domestic currency increases its demand and thus its value, while selling domestic currency has the opposite effect. This method is often used to counter short-term fluctuations in the exchange rate.
⭐Indirect intervention: This involves using other policy tools to influence the exchange rate. For example, raising interest rates can attract foreign capital, increasing demand for the domestic currency and appreciating its value. Similarly, capital controls can limit the flow of capital in and out of the country, thereby influencing the exchange rate.


Effectiveness of Intervention: Arguments For
Advocates for exchange rate intervention argue that it can be effective in certain circumstances:

⭐Short-term volatility: Intervention can be useful in countering short-term speculative attacks on a currency. By buying domestic currency, the central bank can stabilize the exchange rate and prevent it from depreciating excessively. It can also be used to smooth out fluctuations in the exchange rate due to temporary shocks, such as news events or political uncertainty. For example, in 1997, the Thai baht came under pressure from speculative attacks due to concerns about the country's financial system. The Bank of Thailand intervened heavily by selling dollars and buying baht, but ultimately the intervention was not enough to prevent the currency crisis. This suggests that intervention can be effective in stabilizing short-term volatility, but it may not be sufficient to address deeper economic problems.
⭐Combined with other policies: Exchange rate intervention is often most effective when used in conjunction with other policy tools, such as fiscal policy or structural reforms. For example, a central bank might raise interest rates while simultaneously intervening in the foreign exchange market to strengthen the currency and reduce inflationary pressures.


Effectiveness of Intervention: Arguments Against
Critics of exchange rate intervention argue that it can have significant drawbacks:

⭐Depleting reserves: Intervention can be expensive, especially when the central bank is attempting to resist a sustained depreciation of the currency. This can lead to a depletion of foreign currency reserves, which can make it difficult to defend the currency in the future. Economists often cite the example of the East Asian financial crisis in the late 1990s, where several countries, including Thailand, Malaysia, and South Korea, were forced to abandon their fixed exchange rate regimes due to insufficient foreign reserves.
⭐Market distortions: Intervention can send incorrect price signals to market participants. This can lead to misallocation of resources, as investors may base their decisions on artificially supported exchange rates rather than the true market value of the currency. For example, if a central bank intervenes to maintain an artificially strong currency, it may discourage exports and encourage imports, as domestic goods become more expensive and foreign goods become cheaper. This can lead to trade imbalances and a loss of competitiveness in the global market.
⭐Retaliation and currency wars: Intervention can trigger retaliatory measures by other countries. If one country intervenes to depreciate its currency, other countries may feel compelled to do the same, leading to a “currency war” where countries compete to weaken their currencies to gain a trade advantage. This can harm global economic stability, as it can fuel trade protectionism and create uncertainty for businesses.


Conclusion
The effectiveness of exchange rate intervention in achieving external balance is a complex issue with no easy answers. While intervention can be effective in countering short-term volatility and when used in conjunction with other policy tools, it can also lead to unintended consequences, such as depletion of reserves, market distortions, and retaliation from other countries. The effectiveness of intervention ultimately depends on the specific economic context and the policy goals of the central bank.

It is essential to consider the long-term implications of intervention and the potential for unintended consequences. In many cases, it may be more effective to address the underlying factors driving the exchange rate, such as structural imbalances or weak economic fundamentals. These factors may require a comprehensive approach involving fiscal, monetary, and structural reforms, rather than relying solely on exchange rate intervention.

Ultimately, the decision to intervene in the foreign exchange market should be based on a careful assessment of the risks and benefits. The central bank must weigh the potential gains from stabilizing the exchange rate against the costs of intervention, such as the depletion of reserves and the potential for market distortions. Moreover, the central bank must consider the broader economic context and the potential for retaliation from other countries.

Sources:

"Exchange Rate Intervention and Economic Stability," International Monetary Fund, 2012.
"The Effectiveness of Exchange Rate Intervention: A Survey of the Literature," by Charles Engel and Kenneth West, Journal of Economic Perspectives, 2005.
"Currency Wars: A Threat to Global Economic Stability," by Paul Krugman, 2010.