Discussion Papers In Economics
And Business

THE POLITICAL ECONOMY OF FOREIGN EXCHANGE MARKET INTERVENTION

Shinji Takagi, Kenichi Hirose, and Issei Kozuru

Discussion Paper 12-04

Graduate School of Economics andOsaka School of International Public Policy (OSIPP)
Osaka University, Toyonaka, Osaka 560-0043, JAPANTHE POLITICAL ECONOMY OF FOREIGN EXCHANGE MARKET INTERVENTION

Shinji Takagi, Kenichi Hirose, and Issei Kozuru

Discussion Paper 12-04

March 2012

Graduate School of Economics andOsaka School of International Public Policy (OSIPP)
Osaka University, Toyonaka, Osaka 560-0043, JAPANTHE POLITICAL ECONOMY OF FOREIGN EXCHANGE MARKET INTERVENTION*
Shinji Takagi†, Kenichi Hirose††, and Issei Kozuru†††

ABSTRACTThe paper presents a political economy model of official foreign exchange market
intervention and tests the model against the recent experience of Japan. In several industrial
countries, the government is responsible for intervention decisions while the central bank isgiven operational independence in its conduct of monetary policy. The paper models theinteraction between the two agencies, empirically tests the central bank reaction function,and considers conditions under which intervention might change monetary policy. Daily
Japanese intervention data give broad support to the prediction of the model with respect tocentral bank behavior. Although it is difficult to be definitive about the hidden motive ofcentral bank actions, during the extraordinary period of 2001-04 when Japan remained
under deflationary pressure, the central bank, faced with large political costs of sterilization,accommodated a considerable portion of the massive interventions made by thegovernment. Under normal conditions coordination between the two agencies might bedesirable, not least to make the signal of any intervention credible, but giving an alternative
agency the authority over intervention decisions can be a means of enhancing democratic
accountability for an independent central bank while preserving the credibility of monetary
policy.
JEL classification numbers: E42, E58, F31
Keywords: foreign exchange market intervention; central banking; quantitative easing;Japanese intervention*The authors thank Charles Engel and Hali Edison for useful comments. All remaining
errors are their own responsibility.
†

Shinji Takagi, Graduate School of Economics, Osaka University: takagi@econ.osaka-u.ac.jp††

Kenichi Hirose, Otaru University of Commerce: hirose@res.otaru-uc.ac.jp†††

Issei Kozuru, Kosei Securities: ikoduru@kosei.co.jp

INTRODUCTION
This paper presents a political economy model of official foreign exchange market
intervention, tests the model against the recent experience of Japan, and considers whether
intervention systematically influenced monetary policy. In some countries (which include
Japan, the United Kingdom, and the United States), 1 the official entity responsible forintervention decisions is different from the one responsible for monetary policy. 2 But
foreign exchange market intervention, which alters the balance of base money, necessitatesa monetary policy decision, thus presenting a potential conflict between intervention andmonetary policy. A question naturally arises as to why such a system exists in the firstplace, how it functions in practice, and whether it delivers an outcome different from that
under an alternative system (where the central bank is made responsible for bothintervention and monetary policy decisions). The paper is a modest, first attempt to explore
these issues of institutional design with respect to foreign exchange and monetary policies.
While Japan is not alone in having two separate entities for intervention andmonetary policy decisions, it provides an ideal setting for considering the political economy
of foreign exchange market intervention in such a system, given the sheer scale ofintervention (conducted by the Ministry of Finance) under quantitative easing (pursued by1

In the United States legal ambiguity exists as to the respective roles of the Treasury and the Federal Reserve,
but Treasury supremacy over exchange rate policy has developed through bargaining and decades ofcooperation and has not been challenged (Destler and Henning 1989). FRB (2005) states: “The Federal
Reserve conducts foreign currency operations [..,] acting in close and continuous consultation and cooperation
with the U.S. Treasury, which has overall responsibility for U.S. international financial policy.
2
These countries, however, appear to be in the minority. In a Bank for International Settlements paper,
Moser-Boehm (2005) reports that, out of the 22 countries surveyed in December 2004 for the study (which
exclude Japan, the United Kingdom, and the United States), 19 countries had an arrangement in which central
banks had the authority to make decisions for intervention; two out of the remaining three countries had asystem in which central banks and governments shared the responsibility. In contrast, the government, not thecentral bank, determines the choice of exchange rate regime in the overwhelming majority of countries(Lybek and Morris 2004).

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the Bank of Japan) during 2001-04. After a prolonged period of economic stagnation
characterized by low economic growth and deflation, in March 2001, the Bank of Japan(BOJ) adopted what became known as the quantitative easing monetary policy (QEMP). It
consisted of three pillars: (i) the BOJ supplied ample liquidity by using the deposits ofcommercial banks held at the central bank (current account balances, or CAB)—a
component of the monetary base—as the main operating target; (ii) it publicly committed
itself to maintaining ample liquidity until core consumer price index (CPI) inflation becamezero or higher on a sustained basis; and (iii) it increased the purchases of Japanese
government bonds (JGBs) to inject liquidity (see Maeda et al. 2005 for technical details).
For the period of QEMP as a whole, the Ministry of Finance (MOF) intervened in
the foreign exchange market over 130 times (using its own balance sheet, but acting
through the Bank of Japan as its agent), with a cumulative sale of about 42 trillion yen(about $380 billion). While the MOF’s policy at the outset of the QEMP period was tointervene decisively but infrequently, the intervention tactic changed in January 2003 whenintervention became both frequent and large-scale (Figure 1). During the 15-month periodof the so-called “great intervention” (from January 2003 through March 2004), 3 theauthorities sold for US dollars a cumulative sum of 35 trillion yen, an amount equivalent to
7 percent of Japan’s annual GDP. In 2003 and 2004, the purchases of foreign assets by the

3

In Japan, the great intervention has also been named as the Mizoguchi-Taylor intervention after Zenbei
Mizoguchi and John B. Taylor who were at the time largely responsible for making or condoning theJapanese government’s intervention decisions as Japanese Vice Minister of Finance and US Treasury
Undersecretary, respectively. Taylor explained that by “adopting a more tolerant position toward
intervention—especially if it went unsterilized” the US position was to “help to increase the money supply inJapan” (Taylor 2007, p.286). The 22 March 2004 issue of Business Week magazine, calling Mizoguchi “Mr.
Dollar,” described him as “a faceless bureaucrat in a town full of them [who] enjoys celebrity status” in
trading pits in London and New York.

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public sector were so large that the private sector recorded a capital account surplus eventhough the country had a large surplus in the current account. The great intervention ended
abruptly on 16 March 2004, though QEMP would last until March 2006. 4
The fact that the BOJ was pursuing QEMP is of critical importance. The Bank ofJapan Law guarantees the central bank’s operational independence from government
oversight in its conduct of operations aimed at price and financial system stability. If the
BOJ had been under the more normal operating procedure of most contemporary advanced
country central banks, it would have had to sterilize any impact of intervention on themonetary base in order to maintain the short-term policy interest rate (the overnight callrate in the case of Japan) at a target level. 5 Then, an intervention decision would have been
largely divorced from a monetary policy decision, as should be the case when an
independent central bank desires to maintain the credibility of its monetary policy. Under
these circumstances, the MOF can only hope to influence the level of foreign exchange
reserves and the composition of base money. Intervention could still affect the exchange
rate but only through the signaling and portfolio balance channels, 6 the substantive andlasting effectiveness of which is generally considered in the literature as limited at best
(Edison 1993; Sarno and Taylor 2001).

4

The Japanese authorities would not intervene in the foreign exchange market at all until 15 September 2010.
The September 2010 intervention was a one-time event in which they sold 2.1 trillion yen for US dollars.
5
Even with interest rate targeting, however, sterilization would not have been necessary if interest had been
paid on excess reserves, in which case the interest rate on excess reserves becomes the floor below whichmarket interest rates cannot fall. The Bank of Japan only began to pay interest on excess reserves in
November 2008.
6
If the signaling effect works by influencing market expectations about the future stance of monetary policy,
it may be absent in a system where the entity responsible for intervention cannot make a credible commitment
to the future actions of an independent central bank. This issue is discussed further in a later section of thispaper.

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Under quantitative easing, on the other hand, there is potential room forcollaboration between intervention and monetary policy decisions. It is conceivable in thecase of Japan, for example, that the BOJ could use the MOF’s intervention (to purchaseforeign assets) as an instrument of achieving a particular CAB target. During the period
under consideration, moreover, the policy interest rate was virtually zero. This means that,given the zero lower bound, the BOJ was not constrained by the operational requirements
to sterilize the impact of intervention on the monetary base with a view to maintaining theinterest rate at a particular level. These considerations motivate our strategy of building apolitical economy model of intervention where separate entities are responsible forintervention and monetary policy decisions, and testing it against the experience of Japan
during 2001-04.
The rest of the paper is organized as follows. Section I constructs a simple political
economy model of the interaction between the Ministry of Finance (an entity responsiblefor intervention decisions) and the Bank of Japan (an entity responsible for monetary policy
decisions while acting also as the government’s agent for intervention operations). Section
II estimates the Bank of Japan reaction function derived from the theoretical model, inorder to see how monetary policy decisions responded to intervention decisions within themonetary policy framework of 2001-04. Section III considers the broader political economy
question of whether the Ministry of Finance altered the behavior of the central bank withrespect to monetary policy decisions, through its massive interventions in the foreignexchange market. Finally, section IV presents concluding remarks.

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I. A POLITICAL ECONOMY MODEL OF INTERVENTION
Modeling the interaction between the MOF and the BOJ
We construct a simple political economy model of the interaction between the
MOF (responsible for intervention decisions) and the BOJ (responsible for monetary policyor sterilization decisions) to reflect the circumstances of the 2001-04 period of quantitativeeasing when intervention was all in the direction of purchasing US dollars in exchange forJapanese yen. Let x denotes the amount of intervention, z ( ∈ [0, x] ) the amount of~ the initial (pre-intervention) level of the monetary base, and ~sterilization, ms the initiallevel of the exchange rate defined as units of yen per US dollar. Here, in view of theeconomic environment in Japan during the period of quantitative easing, a positive value ofx means a net sale of yen for US dollars (and we do not consider a negative value for x ).
Suppose that the MOF intervenes in the foreign exchange market to sell yen fordollars and that the BOJ responds subsequently by sterilizing part or all of the intervention.
Then, the monetary base m becomes:~+x−z.
m=m(1)

By linear approximation, the expected value of the exchange rate ( s e ) is assumed to be:
se = ~
s +α x −δ z ,(2)

where α > δ > 0 . By postulating equation (2) we are not asserting that intervention
influences the exchange rate in a particular way. It is possible that intervention, whether
sterilized or unsterilized, does not in reality influence the level of the exchange rate.
Equation (2) simply notes that the authorities when intervening in the foreign exchange-5-market believe that they are influencing the future exchange rate in a particular way.
Otherwise, there would be no reason to intervene in the first place.
We assume that the objective functions (or loss functions) of the MOF and the BOJ
are given, respectively, by the following equations:
L1 = λ1 ( s e − s1∗ ) 2 + µ1 (m − m1∗ ) 2 + Θ( x) ,(3)

L2 = λ 2 ( s e − s 2∗ ) 2 + µ 2 (m − m2∗ ) 2 + Σ( z ) ,(4)

where λ1 > 0 , µ1 ≥ 0 , λ 2 ≥ 0 , and µ 2 > 0 ; s1∗ and m1∗ are the MOF’s targets for theexchange rate and the monetary base, respectively; and s 2∗ and m2∗ are the BOJ’s
counterparts. These functions can be considered as the “reduced forms” obtainable fromminimizing the respective loss functions that explicitly contain inflation and GDP gap(Barro and Gordon 1983; Woodford 2010). 7 The assumed signs of the parameters imply
that the MOF (BOJ) may not care about the base money (the exchange rate), given theirassigned roles in Japan’s economic policymaking apparatus. In this case, µ1 (for the MOF)
and λ 2 (for the BOJ) would be zero. In fact, we later assume that the BOJ has no target for
the level of the exchange rate ( λ 2 = 0 ) in one of the empirical specifications. 8
Because we only consider yen-selling intervention in an environment of~ . Θ(x) in equation (3) represents
deflationary pressure, we assume that s1* > ~s and m1∗ > m

7

If we start out with explicit loss functions defined by inflation and GDP gap, we obtain the secondary loss
functions (corresponding to equations (3) and (4)) as polynomials in s and m. It is only for the sake ofsimplification that we start with loss functions defined directly by s and m.
8
On the other hand, a strong case can be made for believing that the Ministry of Finance had an implicit
target for the monetary base (or money supply) in the early 2000s. In the fall of 2001, the government made ita central pillar of macroeconomic policy to fight deflation and subsequently included monetary policy (theexclusive domain of the central bank) in a package of measures to be implemented (Yoshikawa 2009).

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the cost of intervention (which satisfies Θ(0) = 0 , Θ′ > 0 , and Θ′′ > 0 ), and Σ(z ) inequation (4) represents the cost of sterilization (which satisfies Σ(0) = 0 , Σ' > 0 , andΣ ′′ > 0 ). These costs not only reflect the transactions and administrative costs of relevantmarket operations but also may involve political and other considerations. For example, theMOF may receive foreign criticism for intervention if it is large and sustained; the BOJ
may likewise receive criticism or harassment from the MOF or politicians for sterilization
operations and face the risk of increasing market volatility as the scale of sterilization rises.
Both of these costs are modeled as quadratic, such that: Θ( x) = θ1 x + θ 2 x 2 ( θ1 > 0 , θ 2 > 0 )and Σ( z ) = σ 1 z + σ 2 z 2 ( σ 1 > 0 , σ 2 > 0 ).
Finally, the MOF makes intervention decisions while taking into account thereaction of the BOJ in terms of any sterilization. As for the BOJ, it takes the amount ofintervention x as given and makes a sterilization decision so as to minimize the value of

L2 . The amount of sterilization z can therefore be represented as the reaction functionz = Ψ (x) . The MOF takes this reaction function into account when it determines theamount of intervention x so as to minimize the value of L1 .
The optimization problem for the BOJ
Following the method of backward solution, we first consider the optimization
problem for the BOJ, given the amount of intervention x . Substituting equations (1) and(2) into equation (3), we obtain:~ + x − z − m∗ ) 2 + σ z + σ z 2
L2 = λ 2 ( ~s + αx − δz − s 2∗ ) 2 + µ 2 (m212
Differentiating with respect to z , we have:

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∂L2
= 2(λ 2δ 2 + µ 2 + σ 2 )( z − ψx + ω ) ,∂zwhere ψ ≡~) + 1 σ
λ 2δ ( s 2∗ − ~s ) + µ 2 (m2∗ − m
λ 2αδ + µ 2
2 1
and; we here
(
>
0
)
ω
≡
2
2
λ 2δ + µ 2 + σ 2
λ 2δ + µ 2 + σ 2

assume ψ < 1 because σ 2 is positive in the specification for the cost of sterilization.
Because the BOJ has two potential targets (the monetary base and the exchangerate), we must consider the following two cases, depending on the deviation of the actual~ ) in relation to the deviation of the actual exchangemonetary base from the target ( m2∗ − mrate from the target ( s 2∗ − s ):~ ) > −λ δ ( s ∗ − ~[A] ω > 0 ⇔ µ 2 (m2∗ − ms ) − 12 σ 1 (the initial deviation of the22

monetary base from the target is sufficiently large)~ ) < −λ δ ( s ∗ − ~[B] ω < 0 ⇔ µ 2 (m2∗ − ms ) − 12 σ 1 (the initial deviation of the22

monetary base from the target is sufficiently small)
We consider these cases in turn below.
First, in Case A ( ω > 0 ), the optimal value of z is given by:
if x ≤ ω /ψ0z = Ψ ( x) = ψx − ω if x > ω /ψ(5)

If the amount of intervention x is below the critical level ω /ψ , the BOJ does not sterilize
the intervention at all. If the amount of intervention x is above the critical level ω /ψ , on
the other hand, the BOJ only partially sterilizes the intervention. The reaction functionz = Ψ (x) can be depicted as Figure 2, which essentially shows that the central bank wants-8-

to use the intervention as a means of achieving the target for the monetary base when there
is a large shortfall in the balance of base money.
Second, in Case B ( ω < 0 ), the optimal value of z is given by:
if x ≤ −ω /(1 − ψ )xz = Ψ ( x) = ψx − ω if x > −ω /(1 − ψ )(6)

If the amount of intervention x is below the critical level − ω /(1 − ψ ) , the BOJ fullysterilizes the intervention. If the amount of intervention x is above the critical level− ω /(1 − ψ ) , on the other hand, the BOJ only partially sterilizes the intervention. The
reaction function z = Ψ (x) in this case can be depicted as Figure 3. The kinked line
essentially incorporates the behavior of the central bank that sterilizes the intervention fullyor partially when the monetary base target is already reached or the shortfall in the balanceof base money is small.
The optimization problem for the MOF
Having considered the optimization problem for the BOJ, we next consider the
optimization problem for the MOF, given the BOJ’s reaction function z = Ψ (x) . Hereagain, we must separately consider two cases, A and B, corresponding to ω > 0 and ω < 0 ,respectively. First, in Case A ( ω > 0 ), substituting equations (1), (2), and (5) into equation(4), we obtain:
 LI ( x) if x ≤ ω /ψL1 =  II1
,
L
x
x
(
)
if
ω
/
ψ
>
 1
~ + x − m ∗ ) 2 + θ x + θ x 2 , andwhere: L1I ( x) = λ1 (~s + αx − s1∗ ) 2 + µ1 (m112~ + x − (ψx − ω ) − m ∗ }2 + θ x + θ x 2 .
L1II ( x) = λ1{~s + αx − δ (ψx − ω ) − s1∗ }2 + µ1{m
1
1
2

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Further differentiating with respect to x , we obtain:
dL1I ( x)~ ) − 1 θ }] ,= 2[(λ1α 2 + µ1 + θ 2 ) x − {λ1α ( s1∗ − ~s ) + µ1 (m1∗ − m
2 1dx
dL1II ( x)= 2[{λ1 (α − δψ ) 2 + µ1 (1 − ψ ) 2 + θ 2 }xdx
~ − ω ) − 1 θ }] .
− {λ1 (α − δψ )( s1∗ − ~s − ω ) + µ1 (1 − ψ )(m1∗ − m
2 1

Because the MOF is assumed to have its own potential targets for the exchange rate
and the monetary base, there are three separate cases to consider for the optimal value of x ,depending on the relative sizes of the deviation of the actual exchange rate from the target~ ).
( s1∗ − s ) and the deviation of the actual monetary base from the target ( m1∗ − mCase A1: If~) − 1 θ
λ1α ( s1∗ − ~s ) + µ1 (m1∗ − m
2 1< 0 , the optimal value of x is x = 0 .
2
λ1α + µ1 + θ 2~) − 1 θ
λ1α ( s1∗ − ~s ) + µ1 (m1∗ − m
2 1Case A2: If 0 << ω /ψ , the optimal value of x is given
λ1α 2 + µ1 + θ 2

by:x=Case A3: If~) − 1 θ
λ1α ( s1∗ − ~s ) + µ1 (m1∗ − m
2 1(∈ (0, ω /ψ )) .
2
λ1α + µ1 + θ 2~) − 1 θ
λ1α ( s1∗ − ~s ) + µ1 (m1∗ − m
2 1> ω /ψ
2
λ1α + µ1 + θ 2

 and
dL1II (ω /ψ )< 0  , the optimaldx
value of x is given by: 9~) − 1 θ
λ1α ( s1∗ − ~s ) + µ1 (m1∗ − m
dL1II (ω /ψ )2 1
and> 0 , the optimal value of x is
> ω /ψdx
λ1α 2 + µ1 + θ 2
x = ω /ψ .

9

If

- 10 -

~ − ω) − 1 θ
λ1 (α − δψ )( s1∗ − ~s − ω ) + µ1 (1 − ψ )(m1∗ − m
2 1x=( > ω /ψ ) .
22
λ1 (α − δψ ) + µ1 (1 − ψ ) + θ 2

To summarize in words, if the exchange rate and monetary base deviations from the target~ ) are sufficiently small (Case A1), the MOF does not intervene in the( s1∗ − s ) and ( m1∗ − mforeign exchange market at all. When intervention does take place, the amount rises withthe size of the deviation. In Case A2, where the amount of intervention is smaller thanω /ψ , the BOJ does not sterilize the intervention at all. In Case A3, where the amount ofintervention is larger than ω /ψ , the intervention is partially sterilized.
Next, we consider Case B, where we have ω < 0 . Substituting equations (1), (2)and (6) into equation (4), we obtain:

 LIII ( x) if x ≤ −ω /(1 − ψ )L1 =  1II,
 L1 ( x) if x > −ω /(1 − ψ )~ − m∗ ) 2 + θ x + θ x 2 .
where: L1III ( x) = λ1 (~s + αx − δx − s1∗ ) 2 + µ1 (m112Further differentiating with respect to x , we obtain:
dL1III ( x)= 2[{λ1 (α − δ ) 2 + θ1 }x − {λ1 (α − δ )( s1∗ − ~s ) − 12 θ1 }]dx
In this case, depending on how the actual exchange rate deviates from the target( s1∗ − s ), there are three separate cases to consider for the optimal value of x , as follows:

λ1 (α − δ )( s1∗ − ~s ) − 12 θ1Case B1: If< 0 , the optimal value of x is x = 0 .
λ1 (α − δ ) 2 + θ 2
Case B2: If 0 <λ1 (α − δ )( s1∗ − ~s ) − 12 θ1< −ω /(1 − ψ ) , the optimal value of x is given by:
λ1 (α − δ ) 2 + θ 2- 11 -

λ1 (α − δ )( s1∗ − ~s ) − 12 θ1x=(∈ (0,−ω /(1 − ψ )) .
λ1 (α − δ ) 2 + θ 2
Case B3: Ifλ1 (α − δ )( s1∗ − ~s ) − 12 θ1
dL1II (−ω /(1 − ψ )) , the
and
<
0
/(
1
)
ω
ψ
>
−
−

dx
λ1 (α − δ ) 2 + θ 2


optimal value of x is given by: 10x=~ − ω) − 1 θ
λ1 (α − δψ )( s1∗ − ~s − ω ) + µ1 (1 − ψ )(m1∗ − m
2 1(> −ω /(1 − ψ )) .
22
λ1 (α − δψ ) + µ1 (1 − ψ ) + θ 2

In words, if the deviation s1∗ − s is sufficiently small (Case B1), the MOF does notintervene in the foreign exchange market at all; when intervention does take place, theamount of intervention x rises with the size of the deviation. In Case B2, where the amountof intervention is smaller than − ω /(1 − ψ ) , the BOJ fully sterilizes the intervention. Finally,in Case B3 where the amount of intervention is larger than − ω /(1 − ψ ) , the BOJ only
partially sterilizes the intervention.
II. ESTIMATING THE BANK OF JAPAN REACTION FUNCTION
Empirical specification of the BOJ reaction function
The Bank of Japan’s possible behavior with respect to sterilization is indicated byequations (5) and (6) of our political economy model, which specify its reaction under
different sets of conditions to the size of intervention (as determined by the Ministry of
Finance). Given the operational framework in place during the period of QEMP, the central
bank reaction function derived from our political economy model would lead us to expect

λ1 (α − δ )( s1∗ − ~s ) − 12 θ1
dL1II (−ω /(1 − ψ ))and
> 0 , the optimal value of x is> −ω /(1 − ψ )dx
λ1 (α − δ ) 2 + θ 2
x = −ω /(1 − ψ ) .

10

If- 12 -

that the BOJ was reluctant to fully accommodate the resulting reserve inflows associatedwith a large intervention, when it did not wish to allow the CAB target to be exceeded by alarge margin. On the other hand, the model would have us believe that the central bank was
more willing to accommodate the reserve inflows when the prevailing CAB level was well
below the target. In specifying the empirical version of the central bank reaction function
below, we will try to capture explicitly the size of each intervention relative to the existingor prospective deviation between the actual CAB and the target.
Incorporating these ideas into equations (5) and (6), we specify the following
empirical reaction function, which we will estimate by using daily data for the period of
QEMP:
dCABt = c1 + β11 ITVt-2 + β12 [D1 ITVt-2]+ β13 [D2 ITVt-2]+ ε1t(7)where dCAB is a daily change in CAB, ITV is daily intervention (lagged two business days
to reflect t+2 settlement); c1 is a constant; β11, β12 and β13 are parameters to be estimated; ε1
is a random error term; and D1 and D2 are dummy variables that represent the size ofintervention relative to the CAB target. Specifically, D1 takes the value of unity (zerootherwise) when CABt-1 is below the target (at t-1) and ITVt-2 is larger than the deviation(at t-1), such that the target is exceeded at settlement if fully accommodated; D2 takes thevalue of unity (zero otherwise) when CABt-1 is below the target (at t-1) and ITVt-2 issmaller than the deviation (at t-1), such that the target is not exceeded at settlement even if
fully accommodated.
The specification of equation (7) incorporates the implications of the theoreticalmodel that, even if the CAB is below the target, the central bank may not fully- 13 -

accommodate a (typically) large intervention that, if fully accommodated, will cause thetarget to be exceeded. Thus, we hypothesize that β11+ β12 <1. On the other hand, the central
bank is more likely to fully accommodate a (typically) small intervention that will not cause
the target to be exceeded even when fully accommodated. In this case, we hypothesize thatβ11+ β13 =1. If CABt-1 already exceeds the target, both dummy variables take the value ofzero, so that we have:dCABt = c1 + β11 ITVt-2 + ε1t(7’)

If the central bank fully sterilizes the intervention, we have β11=0; otherwise, 0<β11<1.
In terms of the theoretical model, these empirical specifications correspond to theassumptions that λ 2 = 0 (the BOJ does not have a target for the exchange rate) and σ 1 = 0~ > 0 in(the cost of sterilization only has a quadratic term), which together imply m2∗ − m~ < 0 in Case B. That is to say, these restrictions mean that the BOJ only
Case A and m2∗ − mconsiders the deviation of the monetary base from the target when making sterilization
decisions. 11 In Case A, the critical value of the reaction function then becomes~ . This means that, when x > ω /ψ , CAB is below the target (at t-1) andω /ψ = m2∗ − mt-1
ITVt-2 is larger than the deviation (at t-1), corresponding to D1=1. Equation (5) then means
β11+ β12 <1. When x < ω /ψ , CABt-1 is below the target (at t-1) and ITVt-2 is smaller thanthe deviation (at t-1), corresponding to D2=1. Equation (5) in this case means β11+ β13 =1.
In Case B, on the other hand, CABt-1 exceeds the target (at t-1), corresponding to D1=D2=0.
Thus, equation (6) in this case means β11=0 if x < −ω /(1 − ψ ) or 0<β11<1 if x > −ω /(1 − ψ ) .
11This is not an unreasonable assumption because the central bank was likely more concerned about macroprudential risks than the explicit level of the exchange rate.

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Equation (7) was estimated by using the average realized CAB balance as the target
CAB when the BOJ’s announced target implied a range, rather than a single value (see thenext section for details). The daily data come from the 3-year period covering 19 March
2001 to 16 March 2004 and include 130 days of intervention; they exclude six intervention
days when the Japanese market was closed because the BOJ did not engage in domestic
market operations on those days. The empirical results broadly support the implications of
the political economy model, namely, the BOJ allowed the monetary base to rise in
response to intervention only when there was a shortfall in meeting the CAB target (Table1). When there was no shortfall, intervention was fully sterilized, such that the coefficientof intervention in such cases (β11) was statistically insignificant. On the other hand, thecoefficients of the slope dummies (representing the size of intervention) were both
statistically significant. Moreover, the degree of accommodation was larger when the sizeof intervention was smaller than the CAB shortfall, compared to a situation where the sizeof intervention was larger than the deviation, such that β12 < β13. In fact, the hypothesis of
β13=1 cannot be rejected (with a t-statistic of 0.0124), suggesting that the BOJ fully
accommodated an intervention whose size was smaller than the deviation.
Incorporating non-linear behavior
The linear model of equation (7) explains the Bank of Japan’s daily reaction tointervention remarkably well, but it may fail to uncover an important non-linearity incentral bank behavior (which may be reflected in the low R-squared). For example, the BOJ
may have become progressively more determined to accommodate intervention when a- 15 -CAB deviation was larger. With such non-linearity, it is possible that the degree ofaccommodation was not constant but intensified as the deviation increased in size.
In fact, such possibility can be shown in our theoretical model by comparing thereaction functions for different deviations of the monetary base from the target. For
example, consider the following five deviations of the monetary base from the target:~ = M 1 , M 2 , M 3 , M 4 , and M 5 ( M 1 > M 2 > M 3 > M 4 > M 5 ). Then, them2∗ − mcorresponding reaction functions can be depicted as five upward sloping lines, all but oneof which are kinked (Figure 4). Three cases can be considered separately, as follows.
~ = M 3 ) represents the case of ω = 0
First, the only straight line ( m2∗ − m(i.e., M 3 = {−λ 2δ ( s 2∗ − ~s ) − 12 σ 1 } / µ 2 ), in which the reaction function is given by~ = M 1 andz = Ψ ( x) = ψx for ∀x > 0 . Second, the two lower kinked lines ( m2∗ − m~ = M 2 ) are examples of Case A ( ω > 0 ); the critical value of the reaction functionm2∗ − mω /ψ is larger in the case of M 1 than in the case of M 2 . Third, the upper kinked lines~ = M 4 and m ∗ − m~ = M 5 ) are examples of Case B ( ω < 0 ); the critical value of the( m2∗ − m2reaction function − ω /(1 − ψ ) is smaller in the case of M 4 than in the case of M 5 . It isclear from these lines that, given the same amount of intervention x , the size ofsterilization z falls as the deviation becomes larger (as long as sterilization is partial). In
other words, the degree of accommodation ((x-z)/x) rises with the monetary base (or CAB)
deviates more from the target.
Equation (8) below attempts to capture this type of potential non-linearity in thecentral bank’s reaction function:- 16 -

dCABt = c21 + Φt [c22 + β2 ITVt-2] + ε2t(8)where c21 and c22 are constants, β2 is a parameter to be estimated, and ε2 is a random error
term; Φ is a variable that reflects the deviation of the actual CAB from the target (CAB*),defined as:
Φt = [1 + exp {–η2 (DEVt-1 – c23)}]-1(9)where DEVt-1 = CAB*t-1 – CABt-1; η2 is a parameter to be estimated; and c23 is a constant. 12
Note that Φ is defined to lie between zero and unity, i.e., Φ approaches zero [unity] as the
CAB deviation approaches negative [positive] infinity as long as η2 is positive. In equation(8), Φtβ2 indicates the proportion of accommodation—the extent to which the central bankis willing to allow the CAB to move in the direction of intervention.
The results from estimating equation (8) are reported in Table 2. All the coefficientsare found to be statistically significant, except for the constant c21. More meaningful is the
proportion of accommodation or non-sterilization (Φtβ2), which is depicted in Figure 5. It isevident that, as the deviation increases from a negative range to a positive range, theproportion rises progressively from zero. As the deviation increases further, the proportion
approaches unity and goes beyond. We conclude that the BOJ increasingly accommodated
the reserve inflows from intervention when the actual CAB was farther below the target.

III. DID INTERVENTION SYSTEMATICALLY CHANGE MONETARY POLICY?
Intervention and monetary base expansion

The constant c23 is included to depress the value of Φ (toward zero) in the negative range of the CAB
deviation. This specification is motivated by the results from estimating the linear model, where we found thatthe BOJ almost fully sterilized intervention when the deviation was negative.

12- 17 -

We have observed that the Bank of Japan sterilized or accommodated the impact ofintervention on the monetary base according to how much the CAB balance was above or
below the target. This is consistent with the prediction of our political economy model ofcentral bank behavior. This means that, given the CAB target, the BOJ used intervention as
an instrument of monetary policy. As long as the target was the BOJ’s own choice, thecentral bank’s operational independence appeared preserved. But the MOF could haveaffected the CAB balance though massive interventions, either by influencing the BOJ’s
choice of the target or by raising the costs of sterilization. If so, monetary policy was nolonger independent of intervention. The critical political economy question then concerns
the potential endogeneity of the central bank target and the costs of sterilization withrespect to intervention.
In order to consider this question, we first combine the behavior of the BOJ and thatof the MOF (equations (1), (5) and (6) in the theoretical model) to obtain the following~ ) due to the MOF's intervention:
expressions for a change in the monetary base ( m − m

if x ≤ ω /ψ
~ = xCase A : m − m(1 − ψ ) x + ω if x > ω /ψ(10)

if x ≤ −ω /(1 − ψ )~ = 0Case B : m − m(1 − ψ ) x + ω if x > −ω /(1 − ψ )(11)As previously, Case A ( ω > 0 ) represents a situation in which the initial deviation of themonetary base from the BOJ's target is sufficiently large, while Case B ( ω < 0 ) describes asituation in which the initial deviation of the monetary base from the BOJ's target issufficiently small.

- 18 -

Equation (10) states that, in Case A, the change in the monetary base necessarily
becomes larger as the amount of intervention ( x ) becomes larger. On the other hand,equation (11) shows that, in Case B, intervention does not change the monetary base if its
amount is below the critical level − ω /(1 − ψ ) ; if the amount is above the critical level,intervention can still increase the monetary base in this case because the BOJ finds thecosts of sterilization too high. Understanding of the monetary impact of intervention can befacilitated by depicting these equations as diagrams, where x (the amount of intervention) is~ (an increase in the base money) on the vertical axis;
drawn on the horizontal axis and m − mthese are drawn separately for ω > 0 (Figure 6) and ω < 0 (Figure 7). Analogous to Figure~ ) and a4, the relationship between a change in base money due to intervention ( m − m~ ) can also be shown
deviation of the monetary base from the central bank target ( m2∗ − mdiagrammatically (Figure 8). The figure essentially shows how intervention alters themonetary base as the central bank target changes. Given the size of x and the initialbalance of base money, as the target increases, as expected, there tends to be a larger
increase in the monetary base.
The monetary impact of an increase in the costs of sterilization ( Σ ), modeled here
as a quadratic function Σ( z ) = σ 1 z + σ 2 z 2 ( σ 1 > 0 , σ 2 > 0 ), can likewise be analyzed
diagrammatically both for ω > 0 (Figure 9) and for ω < 0 (Figure 10). As the costs are
assumed to involve two components, each of these figures depicts the monetary impact of
an increase in the costs separately for the linear term (case (i)) and for the quadratic term(case (ii)). In all four cases, as the costs of sterilization increase, a given amount ofintervention will have a larger effect on the monetary base (it is only a mathematical- 19 -

artifact that an increase in the linear cost term would lead to an upward, parallel shift in themonetary impact line, whereas an increase in the quadratic cost term causes both an upward
shift and a steeper slope). We have therefore established that sufficiently large andpersistent interventions by the government could alter the monetary policy decisions of thecentral bank by raising the monetary base target, the political costs of sterilization, or both.
Institutional framework of intervention
Some understanding of the institutional frameworks of intervention and quantitativeeasing in place during 2001-04 is essential before assessing whether the Ministry of
Finance was able to alter the behavior of the Bank of Japan through its massiveinterventions. In Japan, the MOF intervenes in the foreign exchange market by using a
special account of the National Budget called the Foreign Exchange Fund Special Account,and through the BOJ acting as its agent. When purchasing (selling) dollars, the MOF issues(redeems) financing bills (FBs), which are short-term government notes. Once issued, FBs
are rolled over continuously as long as the underlying foreign assets are maintained as
foreign exchange reserves. Sale of the underlying foreign assets, however, reduces theoutstanding balance of FBs to the extent that the government redeems them. Because FBs
are sold to (or purchased from) the public at market rates, some have interpreted thisinstitutional arrangement to mean that intervention is automatically sterilized by design (Ito2005; Fatum and Hutchison 2005), a position also reiterated by the Bank of Japan on theimpact of intervention on the monetary base (see Maeda et al. 2005).
This must be qualified in four respects, however, in order to understand themechanics of BOJ operations in response to intervention. First, when FBs are issued for- 20 -

intervention purposes, they are entirely purchased by the BOJ. Because FB auctions areheld weekly, there is no other practical way of conducting foreign exchange market
intervention in a flexible and timely manner. Second, although FBs are sold to the market
during a weekly auction, given the large and continuous rollover needs, the MOF usually
does not repurchase the BOJ-held FBs all at once. 13 Watanabe and Yabu (2007) suggestthat about two months of time elapses between the intervention-induced purchase of FBs by
the BOJ and the public sale of FBs by the MOF executed to unwind the position at the BOJ.
Moreover, nothing would prevent the BOJ from holding the FBs longer or even purchasing
the FBs from the secondary market, as indicated by sharp increases in the BOJ’s holding of
FBs in the first half of 2002, and again in 2003 (Figure 6). Third, outright purchases of
JGBs and other market instruments are another means of unsterilizing foreign exchange
market intervention, 14 notwithstanding the public sales of FBs by the MOF.
Fourth, the BOJ could provide short-term liquidity to the government under
exceptional circumstances. As a recent example, on 26 December 2003, the MOF reachedagreement with the BOJ to sell US Treasury bills (TBs) held as foreign exchange reserves.
This agreement came about in a circumstance where the massive dollar-purchasing
intervention of 2003 had caused the balance of FBs to reach the statutory limit set by the
National Diet. Specifically, the agreement noted that this was a time-bound measure
whereby the BOJ would be prepared to purchase TBs from the Foreign Exchange Fund
13

According to an official of the MOF’s Financial Bureau, as a general practice, up to 300 billion yen of new
FB issues could be accommodated in each auction. This means that if there is a yen-selling intervention of
900 billion, it would take a minimum of three subsequent weekly auctions to unwind the position at the BOJ.
14
The Bank of Japan purchased (in net terms) long-term JGBs worth more than 18 trillion yen, bills worth 34
trillion yen, and equities held by commercial banks worth 3 trillion yen during the period of QEMP. In July
2003, it also began to purchase commercial paper against collateral.

- 21 -

Special Account up to 10 trillion yen until the end of March 2004; it also specified that the
BOJ would resell the TBs back to the Foreign Exchange Fund Special Account within threemonths from purchase. Essentially, the intervention financed by the sale of TBs (with arepurchase agreement) during the first three months of 2004 was unsterilized by definition.
In the event, the maximum balance of 6.15 trillion yen of short-term liquidity was provided
to the MOF under this scheme, which was all unwound during June 2004 (see Figure 11).
Interpreting the BOJ’s balance sheet expansion
Over the period of QEMP, there was a rapid growth in base money (roughly
consisting of current account balances and central bank notes) of over 43 trillion yen, which
was almost exactly matched by a cumulative sale of 42 trillion yen by the Ministry of
Finance in the foreign exchange market. The foreign exchange market intervention during
QEMP can therefore be said to have been entirely unsterilized in terms of its economic
impact, even though a large portion of the FBs initially absorbed by the Bank of Japan may
have been subsequently sold to the public. The growth of base money was accompanied byperiodic increases in the CAB target. Given the endogeneity of the public’s demand forcentral bank notes, the BOJ used the more controllable CAB as an intermediate target ofmonetary policy. Between March 2001 and January 2004, the BOJ raised the target inseveral steps, from about 5 trillion yen to 30–35 trillion yen, which would remain in effectthrough the end of QEMP in March 2006 (Table 3).
At the same time, during the period of QEMP, the BOJ publicly announced theamount of monthly JGB purchases, which it raised, in several steps, from 400 billion yen
initially to 1.2 trillion yen in October 2002 (see Table 3). As a result, the balance of long-- 22 -

term JGBs in the BOJ’s portfolio steadily rose from around 46 trillion yen initially to over
65 trillion yen in March 2004 (Figure 12). An inspection of the BOJ balance sheet indicatesthat about a half of the increase in base money from March 2001 to March 2004 was madepossible by the open market purchases of long-term JGBs, with the other half coming fromthe purchases of other assets (not shown in the figure). The outright purchases of long-term
JGBs were subject to the self-imposed rule (introduced when QEMP began) that thebalance should be kept below the outstanding balance of central bank notes issued (Maeda
et al. 2005). During the period of the great intervention, this rule may have acted as aconstraint on the amount by which intervention was allowed to increase the balance of basemoney.
The critical question for our purpose concerns the motives behind the decision of
the BOJ to raise the CAB target periodically over the course of QEMP. Are we to interpret
the BOJ balance sheet expansion as a response to accommodate the monetary impact oflarge and sustained foreign exchange market interventions by the MOF? If so, the MOF
was successful in using intervention to alter the BOJ’s behavior toward the balance of basemoney, hence the central bank’s otherwise independent monetary policy. Alternatively,
should we think of the periodic increases in the CAB target as an autonomous monetary
policy decision of the BOJ? Oda and Ueda (2007) show that market participants perceived
the successive upward CAB revisions as a signal of greater commitment to monetary- 23 -

accommodation; the announcement and successive upward revisions of the CAB target
were used as a type of signaling device. 15
To be sure, the BOJ was under intense political pressure. In the early 2000s, publicdissatisfaction with the BOJ was so strong that politicians were openly proposing to revise
the Bank of Japan Law (Umeda 2011). Yoshikawa (2009), who was an academic memberof the Prime Minister’s Council on Economic and Fiscal Policy during 2001-2005, reviews
the internal debate between the government and the Bank of Japan on the causes ofdeflation. The government took the view that monetary policy was the cause of deflation
while the BOJ repeatedly argued that deflation was an outcome of economic stagnation. In
the 15 February 2002 meeting of the Council, the Minister of Economy and Industry called
for additional monetary easing, to which the BOJ Governor responded by saying that themonetary easing already in place was more than sufficient and that there was little thecentral bank could do to increase the money supply as long as the economy remained
stagnant.
Given the tense political background, the costs of undoing every effort of thegovernment to inject liquidity through intervention must have been enormous. Watanabe
and Yabu (2007), making a distinction between intervention and other government
payments, 16 used a dynamic regression model to show that, during the period of the great

15

Jung et al. (2005) show in a theoretical model that the optimal monetary policy, when the central bank is
faced with a weak economy and the zero interest rate bound, is to make a credible commitment to maintain
zero interest rates even after the natural rate of interest returns to a positive level, as this would lead to higher
expected inflation, lower long-term interest rates, and a weaker domestic currency.
16
The current account balances of commercial banks increase, not only when the government intervenes in
the foreign exchange market to purchase dollars for yen, but also when it makes pension and other payments
to the private sector (conversely, the CABs decline when the government collects taxes from the private- 24 -

intervention, the BOJ (i) accommodated more of the impact of intervention on the CAB(nearly 55 percent on average) and (ii) allowed the impact to remain longer (up to ninebusiness days), compared with the impact of other government payments (40 percent and
up to two business days, respectively). The fact that the CAB target was raised four times
during the great intervention, from 17-22 trillion yen to 30-35 trillion yen (where the target
would remain until the end of QEMP), is too coincidental to dismiss the possibility that,yielding to political pressure, the BOJ created additional room for unsterilized intervention.
At least, this is how those on the government side seemed to perceive the situation(Mizoguchi 2004).
Remarkable, however, is the complete absence in the Policy Board minutes of any
reference to foreign exchange market intervention. 17 Equally remarkable, not a single
reference to foreign exchange market intervention appears in a book-length analysis ofJapanese monetary policy during 1998-2005 by Ueda (2005), who was a Policy Board
member during that time. It is possible that, given the operational independence of the Bankof Japan, the central bankers conscientiously avoided any appearance of their decisions
being influenced by government actions by keeping complete silence about intervention; it
is unimaginable that they would have admitted yielding to political pressure even if they
had in fact done so.

sector). As is expected, the size of these government payments and receipts far exceeds that of foreignexchange market operations.
17
The minutes of a monetary policy meeting of the Policy Board are released to the public, in the Japaneseoriginal and English translation, a month after the meeting (available at www.boj.or.jp/en/mopo/). These are
not the full transcript. According to the BOJ’s transparency policy, the full transcripts are released to the
public only after 10 years. This means that we must wait until 2013 and 2014 to know if any reference wasmade by any member of the Board to foreign exchange market intervention as a basis for a monetary policy
decision during the great intervention.

- 25 -

But a detailed analysis of each of the nine decisions to raise the CAB target under
QEMP reveals that Board members often disagreed with the proposed decision, leading to a
split vote in six of the nine cases. The Policy Board articulated in each case why an increasein the CAB target was warranted on the basis of its technical assessment of the prevailing
economic and financial conditions; only in one case (20 May 2003) was there a passing
reference to exchange rate volatility (but not foreign exchange market intervention) as partof the background against which the Board took the decision (Umeda 2011). Compelled ina press conference to explain the relationship between foreign exchange market
intervention and the just announced decision to raise the CAB target, on 10 October 2003,
BOJ Governor Toshihiko Fukui stated that the BOJ’s decision to supply liquidity was basedon its assessment of overall economic conditions, and categorically denied any notion thatit had been done to effect unsterilized intervention (as quoted in Umeda 2011, p. 151).
In order to test formally the hypothesis that MOF intervention did not change BOJ
behavior, we use the following ordered probit model:
PBDt∗ = c 3 + β 3 CMI t +ε 3t(12)

0 if PBDt∗ ≤ γ 1
PBDt = i if γ i < PBDt∗ ≤ γ i:+1
9∗
 if γ 9 < PBDt
where PBDt refers to a discrete variable that represents the CAB target at time t, as
determined by one of the ten BOJ Policy Board decisions to raise the CAB target (see Table3), such that PBDt takes the value of 0 for the CAB balance following the first decision,
the value of 1 following the third decision, and so forth; PBDt∗ is an unobservable- 26 -

continuous variable that corresponds to PBDt ; CMI t is the value of cumulativeinterventions up to time t; γi (i=1,9) is a threshold value of PBD ∗ that triggers a BOJ
decision to raise the CAB target to the next level; c3 and β3 are parameters to be estimated;and ε3 is an error term. The maximum likelihood estimates of the parameter β3, along withthe threshold parameters, reject the hypothesis that the Bank of Japan systematically raised
the CAB target in response to the value of cumulative interventions (Table 4). While themodel fits the data fairly well (with a pseudo R-squared of 0.8), the estimated value ofβ3, though positive, is not statistically significant (with the p-value of 0.253). Likewise,
Granger causality tests (not formally reported here) have rejected the hypothesis that MOF
interventions caused the actual CAB balance or the CAB target.
Part of the lack of strong quantitative evidence supporting causality from MOF
interventions to BOJ decisions to raise the CAB target comes from the fact that the Bank ofJapan took several decisions to raise the CAB target aggressively during the first half of theperiod while a greater part of the interventions took place toward the end of the period(Figure 13). But it is still possible that the Bank of Japan raised the CAB target inanticipation of future MOF interventions, in which case MOF interventions did influence
monetary policy. At least, the Bank of Japan created room for unsterilized interventions by
the Ministry of Finance. Iwata (2010), Deputy Governor of the Bank of Japan from March
2003 to March 2008, while stressing the near equivalence between the amount ofintervention and the change in base money as a coincidence, endorsed the MOF-BOJ
interaction as equivalent to central bank purchases of foreign bonds when the acquisition of- 27 -

foreign assets by the government was consolidated with the acquisition of JGBs by thecentral bank.

IV. CONCLUSION
This paper has considered the political economy of foreign exchange market
intervention in a country, such as Japan and the United States, where two separate entities
are responsible for intervention and monetary policy decisions. Noting the large scale ofintervention conducted under the framework of quantitative easing during 2001-04, weused the case of Japan to motivate a theoretical model of the interaction between the
Ministry of Finance (responsible for intervention) and the Bank of Japan (responsible formonetary policy). Estimation of the central bank reaction function derived from the model
confirmed the theoretical prediction, namely, the BOJ determined the degree of sterilizationon the basis of the size of intervention relative to the deviation of the current accountbalances (CAB) from the target. In particular, the BOJ accommodated a greater portion of
the intervention when the actual CAB was farther below the target, while it fully sterilized
when the target was already reached. There was also non-linearity in central bank responsein that non-sterilization became progressively more intense as the CAB deviation waslarger.
An important implication of the political economy model is that the Ministry of
Finance can alter central bank behavior with respect to the monetary base if the central
bank target or the political costs of sterilization become endogenous to the size andpersistence of intervention. Our assessment of whether the MOF changed the monetary
policy of the central bank by injecting liquidity through massive foreign exchange market- 28 -

intervention depends on how we interpret the successive increases in the CAB target madeby the BOJ. Over the period of QEMP, the rapid growth in base money was almost exactly
matched by the amount of cumulative interventions by the Ministry of Finance. While thisis too coincidental to dismiss the possibility that, yielding to political pressure, the BOJ
created additional room for unsterilized intervention, the official minutes of the BOJ Policy
Board meetings are silent about foreign exchange market intervention as a factor in its
monetary policy decisions. Nor do formal econometric tests give quantitative evidence
supporting causality from intervention to monetary policy.
Whether the MOF did or did not in practice change BOJ behavior during 2001-04 isof secondary importance, from the point of view of how society should design an
institutional arrangement for exchange rate and monetary policies. The critical point is that,in a system where the government is in charge of intervention decisions while the central
bank is given operational independence to pursue its own monetary policy objectives, there
is potential room for government interference with the independence of the central bankwhen the political costs of sterilization become large. A conflict could arise if theobjectives, or the judgment of prevailing economic and financial conditions, differed
between the government and the central bank. On the other hand, if the two agencies sharethe same objectives and judgment, a case can be made for eliminating the duplication bytransferring the intervention authority of the government to the central bank, as is alreadythe case in many countries. Then, exchange rate policy can be made consistent with, andsubordinated to, monetary policy, with the exchange rate used as an instrument of- 29 -

achieving price stability (if not to maintain a certain exchange rate level). 18 This type ofarrangement makes sense in some small open economies, such as Singapore, where theexchange rate is a more direct instrument of influencing the price level than a market
interest rate (Parrado 2004); likewise, central banks under inflation targeting should begiven authority to intervene in the foreign exchange market if the domestic price level issignificantly determined by the exchange rate (Gersl and Holub 2006; Kamil 2008).
Under normal conditions it makes little sense for the government to intervene in theforeign exchange market against the judgment of the central bank. Unless interest rates areat the zero lower bound or interest is paid on excess reserves, the central bank is obliged toundo the monetary impact of any intervention operation by the government. Without the
support of the central bank, therefore, intervention would have no monetary policy effecton the exchange rate. Moreover, unless the direction of intervention is the same as the
expected future stance of monetary policy, no signaling effect could be expected in any
case. There is even a possibility that foreign exchange market intervention sends a wrong
signal about monetary policy. It is for this reason that Shirakawa (2008) argues that theauthority to make intervention decisions should be given to the central bank; or at least the
government should be required to consult with the central bank before intervening in theforeign exchange market. This appears to be the case in the United States, where there issaid to be a “mutual veto system” between the Treasury and the Federal Reserve and,18

The central bank cannot pursue price and exchange rate stability at the same time unless it resorts to capital
controls.

- 30 -

according to an informal agreement reached in the late 1970s both agencies usually provide
roughly equal amounts of funds when official intervention does take place (FRB 2005). 19
But what could society do when its independent central bank began to abuse its
power by making a series of wrong decisions? Does it have to sit still until the term of theincumbent governor (or all of its Board members) ends? Or should there be an additional
channel of checks and balances? Endowing the government with the authority to intervenein the foreign exchange market could play such a role of enhancing the democratic
accountability of an independent central bank. In Japan, the Ministry of Finance at leastcame close to using (if not actually used) this authority to expand the balance of basemoney when it thought the policy stance of the Bank of Japan was insufficiently easy. The
benefits are not entirely one-sided. This arrangement, by giving the intervention authority
to the government, protects the central bank from political pressure to intervene especiallyin a country with a powerful trade lobby. It helps preserve the credibility of monetary
policy under normal conditions when the central bank has no intention to change the stanceof monetary policy and intervention is therefore of little efficacy as a tool of exchange rate
policy.
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- 34 -

Yoshikawa, Hiroshi, 2009, “Defureshon to Kinyu Seisaku (Deflation and Monetary
Policy),” Hiroshi Yoshikawa (ed.), Defure Keizai to Kinyu Seisaku, in Japanese,
Tokyo: Keio University Press.

- 35 -

Table 1. Bank of Japan’s Daily Reaction Function under QEMP:A Linear Model

Variable

Coefficient Standard error

t-statistic

Probability

Constant
ITV (β11)
D1 ITV (β 12)
D2 ITV (β 13)199.2551-0.05952
0.732272
1.045596

273.8592
0.212983
0.3141940.368930.727582-0.27944
2.330641
2.834130.467101
0.779982
0.020042
0.004721

Adjusted R-squared

0.019983

Durbin-Watson statistic

1.98939

Notes: D1 and D2 take the value of unity 16 and 43 times, respectively, with all other interventions taking
place when CAB was above the target; the number of observations is 739.

Table 2. Bank of Japan’s Daily Reaction Function under QEMP:A Non-Linear Model

Variable

Coefficient Standard error

t-statistic

Probability

ITV (β2)
DEV (η2)
Constant (c21)
Constant (c22)
Constant (c23)1.535974
0.000128-2957.079
8987.236
7644.518

0.491813
5.73E-05
1975.101
3167.889
3691.805

3.123087
2.239735-1.497179
2.836979
2.070672

0.00190.02540.13480.00470.0387

Adjusted R-squared

0.080123

Durbin-Watson statistic

1.872804

Notes: standard errors and covariance are estimated by White heteroskedasticity-consistent estimators because,
unlike the linear case, heteroskedasticity cannot be rejected; a Ramsey RESET test was used to reject the
hypothesis of linearity (with an F-statistic of 12.891 and the p-value of 0); the restriction β2=1cannot berejected by a Wald test with a chi-square statistic of 1.18765 and the p-value of 0.2758.

- 36 -

Table 3. Monetary Policy Decisions under Quantitative Easing,
March 2001-January 2004
Policy Board meeting where
the decision was made19 March 2001
14 August 2001
18 September 2001
19 December 2001
28 February 2002
30 October 2002
25 March 2003
30 April 2003
20 May 2003
10 October 2003
20 January 2004

Targeted current accountbalances (CAB)
About 5 trillion yen
About 6 trillion yen
Over 6 trillion yen
About 10-15 trillion yen-About 15-20 trillion yen
About 17-22 trillion yen 1/
About 22-27 trillion yen
About 27-30 trillion yen
About 27-32 trillion yen
About 30-35 trillion yen

Monthly purchases of Japanese
government bonds (JGBs)
400 billion yen
600 billion yen-800 billion yen
1 trillion yen
1.2 trillion yen------

1/ Effective 1 April 2003. This was explained as a technical adjustment necessitated by the conversion of the
Postal Services Agency (in charge of postal savings) into Japan Post Public Corporation as part of a long-term
privatization plan.
Source: Bank of Japan.

Table 4. Ordered Probit Model of Bank of Japan Decisions:
Maximum Likelihood Estimates
Variable
β3
γ1
γ2
γ3
γ4
γ5
γ6
γ7
γ8
γ9
Pseudo R-squared

Coefficient

Std. Error

z-Statistic Probability

0.004828
0.004226
1.142332
Threshold parameters0.808073
0.125846
6.4211412.523451
0.405992
6.215518
154.6156
135.6994
1.139398
349.1948
305.4462
1.143228
459.1957
402.3471
1.141292
460.5573
402.3474
1.144676
569.8181
498.8199
1.142332
1090.956
955.1157
1.142223
1592.681
3.29E+11
4.84E-09
0.800380
Observations- 37 -

0.25330.00000.00000.25450.25290.25370.25230.25330.25341.0000739

Source: Ministry of Finance.

Figure 2. The Central Bank Reaction Function ( ω > 0 )z=x(Full sterilization)zz = Ψ (x)

O

x

ω /ψ

- 38 -

Figure 3. The Central Bank Reaction Function ( ω < 0 )

z

O

z=x
(Full sterilization)z = Ψ (x)x− ω /(1 − ψ )Figure 4
Monetary Base Deviations and Corresponding Central Bank Reaction Functions

z

z=x
5
~ = MSmall(Full sterilization) m2∗ − m~ =M4m2∗ − m~ =M3
m2∗ − mDeviation~m2∗ − m~ =M2
m2∗ − m~ = M1m2∗ − mLarge
(M 1 > M 2 > M 3 > M 4 = M 5 )x

O- 39 -

Figure 5. Bank of Japan Response to Daily Intervention,
March 2001-March 2004
1.6

Degree of non-sterilization

1.4
1.2
1
0.8
0.6
0.4
0.2
0
-150000-100000-50000050000

100000

CAB deviation (in billions of yen)

Notes: Zero non-sterilization (on the vertical axis) means that intervention is fully sterilized; a positive
CAB deviation (on the horizontal axis) indicates that the CAB falls short of the target.

Figure 6.
The Monetary Impact of Intervention ( ω > 0 )~=xm−m(Non-sterilization)

~
m−m

O

x

ω /ψ

- 40 -

Figure 7.
The Monetary Impact of Intervention ( ω < 0 )

~
m−m

O

~=x
m−m
(Non-sterilization)x− ω /(1 − ψ )Figure 8.
The Monetary Impact of Intervention When the Target Changes

~
m−m

~=x
m−m
(Non-sterilization)

1~ = MLargem2∗ − m~=M2
m2∗ − m~ =M3
m2∗ − mDeviation~m2∗ − m~=M4
m2∗ − m~ =M5
m2∗ − mSmall
(M 1 > M 2 > M 3 > M 4 > M 5 )x

O- 41 -

Figure 9.
The Monetary Impact of Intervention When the Costs of Sterilization Change ( ω > 0 )(i) The case of an increase in σ 1~=xm−m(Non-sterilization)

~
m−m

O

x

σ 1 ↑ ⇒ ω /ψ ↑(ii) The case of an increase in σ 2~=xm−m
σ 2 ↑ ⇒ 1 −ψ ↑(Non-sterilization)

~
m−m

O

x

ω /ψ

- 42 -

Figure 10.
The Monetary Impact of Intervention When the Costs of Sterilization Change ( ω < 0 )(i) The case of an increase in σ 1~=xm−m(Non-sterilization)

~
m−m

O

x

σ 1 ↑ ⇒ −ω /(1 − ψ ) ↓(ii) The case of an increase in σ 2

~
m−m

~=x
m−m
(Non-sterilization)

σ 2 ↑ ⇒ 1 −ψ ↑O

σ 2 ↑ ⇒ −ω /(1 − ψ ) ↓- 43 -xSource: Bank of Japan.

Source: Bank of Japan- 44 -

Figure 13. Cumulative Interventions (CMI) and Discrete CAB Target Increases (PBD)- 45 -