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Foreign Exchange Intervention: Theory and Policy

Paper Session

Sunday, Jan. 5, 2020 1:00 PM - 3:00 PM (PDT)

Marriott Marquis, Solana
Hosted By: American Economic Association
  • Chair: Sebnem Kalemli-Ozcan, University of Maryland

Foreign Exchange Intervention in Inflation Targeting Latin America

Nicolas Magud
,
International Monetary Fund
Alejandro Werner
,
International Monetary Fund

Abstract

Foreign exchange intervention is widely used as a policy tool, particularly in emerging markets. But many facets of this tool remain limited, especially in the context of flexible exchange rate regimes. The Latin American experience is informative, as some of its largest countries adopted floating exchange rate regimes and inflation targeting while continuing to intervene in foreign exchange markets. This paper summarizes the findings of a recent book that provides insights into how, with what instruments, and with what aim many interventions were decided and implemented. It documents the effectiveness of intervention and pays special attention to the role of foreign exchange intervention policy within inflation-targeting monetary frameworks. The region’s intervention policies have been quite successful, especially owing to transparency and a clear communication policy and, for economies that are not highly dollarized, rules-based intervention that helped contain financial instability and build international reserves while preserving inflation targets.

Foreign Reserves Management

Fabrizio Perri
,
Federal Reserve Bank of Minneapolis
Javier Bianchi
,
Federal Reserve Bank of Minneapolis
Luigi Bocola
,
Stanford University
Manuel Amador
,
Federal Reserve Bank of Minneapolis

Abstract

This paper presents a theory of how a central bank that pursues a monetary policy objective should manage its portfolio of foreign reserves. In particular it studies whether a central bank should hold foreign reserves, and if so what type of assets should it hold. When private agents have limited resources to deploy in domestic financial markets, the central bank can purchase/sell foreign reserves so to affect prices and returns of some domestic securities. By doing so, the central bank can alter the risk-adjusted real rate faced by domestic agents and the allocation of consumption across time and states. Manipulating prices and returns of securities comes at cost, as when the central bank does so, the domestic economy experiences arbitrage losses to foreigners. For a relatively closed economy these losses are minor and it is optimal for the central bank to trade in a variety of risky assets in order to pursue its objectives. For a relatively open economy, the central bank minimizes arbitrage losses and it does so by following a passive portfolio management. In this case, a sufficient condition for optimality is that foreign intermediaries hold domestic risk-free assets.

A Liquidity Theory of FX Intervention

Alessandro Rebucci
,
Johns Hopkins University
Gianluca Benigno
,
London School of Economics
Changhua Yu
,
Peking University

Abstract

We consider a two-sectors (tradable and non-tradable) two assets (reserve and debt) endowment open economy, in which financial markets are not only incomplete but also imperfect because of an occasionally binding collateral constraint on external borrowing that gives rise to sudden stop risk. The private sector can issue risky bonds to smooth consumption and hold safe assets to hedge against sudden stop risk. In this environment of two-way capital flows, we study sterilized foreign exchange (FX) intervention. What can sterilized FX intervention accomplish in welfare terms and through which mechanisms? Does FX intervention differ from capital controls? Can the model help to explain patterns of reserve accumulation and declamation seen in the data? We find that, in a world of two-way capital flows, both FX intervention and controls on capital inflows and outflows can achieve constrained efficiency. FX intervention, however, can also affect the equilibrium allocation when the constraint is binding, thereby not only fulfilling a prudential role, but also a liquidity provision one.

Global Financial Cycle and Liquidity Management

Olivier Jeanne
,
Johns Hopkins University
Damiano Sandri
,
International Monetary Fund

Abstract

Emerging market economies smooth the impact of the global financial cycle through the (private and public) accumulation and deccumulation of liquid foreign assets. We show in the data that the more financially developed a country, the more volatile and correlated are its gross capital inflows and outflows, the lower is the return spread between its foreign liabilities and its foreign assets, and the lower is the share of the central bank's reserves in its outflows. We analyze this behavior using a tractable three-period model. Private agents sell domestic long-term debt to accumulate reserves when the demand of foreign investors is high and buy those assets back when the demand is low. There is scope for government sterilized interventions in countries with lower levels of financial development. In countries with higher levels of financial development the social planner increases the size of gross capital flows so as to stabilize the price of domestic debt. This results in a rent transfer from foreign investors to the domestic economy.
Discussant(s)
Laura Alfaro
,
Harvard Business School
Felipe Saffie
,
University of Maryland
Julien Bengui
,
Bank of Canada
Kinda Hachem
,
University of Virginia
JEL Classifications
  • F3 - International Finance
  • F4 - Macroeconomic Aspects of International Trade and Finance