The Price Elasticity of the Euro to Movements in Foreign Reserves Through European Central Bank Intervention

Abstract

Since its introduction on 1 January 1999, the Euro has become the second most widely traded currency, behind the US Dollar and ahead of the Japanese Yen. Over the first three years of 1999-2001, the weakness of the Euro was a significant feature of foreign exchange markets. The Euro's weakness confounded earlier general expectations that it would trend upward relative to the US Dollar. Movements in exchange rates can be affected by Central Bank intervention. This paper investigates the price elasticity of the Euro to potential European Central Bank intervention. The paper uses a new time-series approach to examine the relationship between the Euro exchange rate and the level of foreign reserves. Conventional methods to test for Granger causal relations among variables, which affect the movements of forex markets, can be undertaken with vector error-correction (VECM) modelling. However the standard VECM approach is traditionally focused on full order time-series structures, which are based on nonzero elements in all elements of all coefficient matrices. Specifically, in tests of indirect causality and/or Granger non-causality in a VECM, the outcome of the causality detection is crucially dependent upon finding zero coefficients where the true structure does indeed include zero coefficients. This VECM, with allowance for possible zero entries in the coefficient matrices, is referred to as a zero-non-zero (ZNZ) patterned VECM. This paper employs ZNZ patterned VECM modelling to investigate Granger causal relations among foreign reserves, the European Monetary Union money supply and the Euro exchange rate. The findings confirm that foreign reserves may influence movements in the Euro's exchange rate. Further, ZNZ patterned VECM modelling with exogenous variables (VECMX modelling) is used to estimate the amount of foreign reserves currently required in order to again achieve a targetted Euro exchange rate, such as the initial rate existing at 1 January 1999.