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 overaccumulate reserves, reducing welfare and leading to inefficiently low world interest rates.

FX intervention and domestic credit: evidence from high-frequency micro data

“…Our paper adds to the literature on …nancial frictions and capital ‡ows (see, for instance, Cavallino (2018), Amador et al ((2017), and Fanelli and Straub (2017)) and engages with the debate on the co-movement of …nancial conditions across markets and the associated policy challenges. Rey (2013) argued that economies may not face a trilemma (incompatibility of …xed exchange rate, open capital account and independent monetary policy), but instead may face a dilemma between free capital ‡ows and independent monetary policy.…”

A Risk-based Theory of Exchange Rate Stabilization

“…4 Another, largely empirical, literature argues that stabilizations may promote bilateral trade or serve to import monetary policy credibility. 5 More closely related to our own work, Fanelli and Straub (2019) and Gabaix and Maggiori (2015) argue real exchange rate interventions can alter the distribution of wealth across agents under segmented markets. Our work complements these other approaches in that the effect of currency stabilization on risk premia may operate in parallel to all of these other mechanisms.…”

“…For a recent example seeFanelli and Straub (2019).17 We define the valuation effect as the (log) difference in the value of the household's traded consumption from its value under freely floating exchange rates.…”

Reserve Accumulation and Bank Lending: Evidence from Korea

“…Since the value of the firm is linear in q, while the constraint is convex in q, the constraint always binds. Substituting the value into the constraint, and aggregating across the unit 5 For example, see Gabaix and Maggiori (2015), Fanelli and Straub (2016), and Amador et al (2016). 6 It is assumed that the exogenous world interest rate R * is smaller than the rate of return z of this economy as we are analyzing private capital inflows.…”