Gradual Portfolio Adjustment, Foreign Exchange Intervention, and Open Market Operations

Rong Li (), Dongzhou Mei () and Bing Tong ()
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Rong Li: School of Finance, Renmin University of China
Dongzhou Mei: School of International Economics and Trade, Central University of Finance and Economics
Bing Tong: Center for Financial Development and Stability at Henan University, and School of Economics at Henan University, Kaifeng, Henan

No 2024/6, CFDS Discussion Paper Series from Center for Financial Development and Stability at Henan University, Kaifeng, Henan, China

Abstract: We introduce gradual adjustment costs for both domestic and foreign bonds in a New Keynesian small open economy model, unifying the theories of foreign exchange intervention and the liquidity effect. With gradual adjustment for foreign bonds, interest rate differentials lead to persistent capital flows. With adjustment costs for domestic bonds, open market operations generate a stronger liquidity effect, which has real effects in an environment with costly intermediation. Furthermore, under gradual portfolio adjustment, nominal interest rates change temporarily in response to asset transactions, so that the model can restore equilibrium when the steady-state asset ratios have changed.

Keywords: Gradual portfolio adjustment; Foreign Exchange intervention; Open market operations; Capital flows; Liquidity effect; Small open economy; New Keynesian model (search for similar items in EconPapers)
JEL-codes: E44 E58 E63 F31 F32 F41 (search for similar items in EconPapers)
Date: 2024-04
New Economics Papers: this item is included in nep-cba, nep-dge, nep-mon and nep-opm
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