A structural threshold model of the exchange rate under optimal intervention

By considering a social trade-off between targeting the exchange rate and minimizing intervention costs, nonlinear exchange rate dynamics can be captured by a structural threshold model. This article provides a theory-based empirical exchange rate model and shows how to put the model into an empirical investigation. To estimate the structural threshold model, we propose a two-step procedure which separately estimates the permanent and temporary fundamentals of the foreign exchange market. A demonstration of our approach is applied to 1981Q3–2008Q3 Taiwan’s foreign exchange market, with a brief review of its monetary policies and central bank given prior. Estimation results are consistent with theoretical predictions and many intervention operations of Taiwan’s central bank are successfully identified.

► We empirically investigate a structural threshold exchange rate model.
► A two-step estimation procedure is proposed.
► We separately estimate the permanent and temporary fundamentals of the FX market.
► Many intervention operations in 1981–2008 Taiwan are successfully identified.