A Theory of Foreign Exchange Interventions

Abstract

We study a real small open economy with two key ingredients: (i) partial segmentation of home and foreign bond markets and (ii) a pecuniary externality that makes the real exchange rate excessively volatile in response to capital flows. Partial segmentation implies that, by intervening in the bond markets, the central bank can affect the exchange rate and the spread between homeand foreign-bond yields. Such interventions allow the central bank to address the pecuniary externality, but they are also costly, as foreigners make carry-trade profits. We analytically characterize the optimal intervention policy that solves this trade-off: (a) the optimal policy leans against the wind, stabilizing the exchange rate; (b) it involves smooth spreads but allows exchange rates to jump; (c) it partly relies on "forward guidance", with non-zero interventions even after the shock has subsided; (d) it requires credibility, in that central banks do not intervene without commitment. Finally, we shed light on the global consequences of widespread interventions, using a multi-country extension of our model. We find that, left to themselves, countries over-accumulate reserves, reducing welfare and leading to inefficiently low world interest rates.

Central Banks as Dollar Lenders of Last Resort: Implications for Regulation and Reserve Holdings

“…Fanelli and Straub (2021) also build a model in which individual countries over-accumulate reserves relative to a global planner's optimum. However the mechanism in their model is quite different, and more "mercantilist" in nature-central bank reserve holdings are driven by a desire to stabilize exchange rate fluctuations.©International Monetary Fund.…”

Optimal Monetary and Macroprudential Policies under Fire-Sale Externalities

“…LawrenceChristiano (2004),Lane and Michael B. Devereux (2005), Gertler, Gilchrist, andNatalucci (2007),Fornaro (2015) study small open economies;Curdia (2008),Braggion, Christiano, and Roldos (2009) andCoulibaly (2019) focus on sudden stop prone economies andChang and Velasco (2017) on unconventional monetary policy. Another literature has studied foreign exchange interventions with imperfect capital markets (see e.g.,Gabaix and Maggiori (2015),Cavallino (2019),Fanelli and Straub (2018),Itskhoki and Mukhin (2022), Amador and others (2020)).8 InCaballero and Krishnamurthy (2003), monetary authorities also face a serious time-inconsistency issue while this is not the case in the current framework.9 Otrok and others (2012) studied monetary and macroprudential policies in a stylized model Loisel (2014). provide a summary of the main findings of several quantitative contributions.…”