A Theory of Foreign Exchange Interventions

Sebastian Fanelli and Ludwig Straub

No 27872, NBER Working Papers from National Bureau of Economic Research, Inc

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 home- and 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.

JEL-codes: F31 F32 F41 F42 (search for similar items in EconPapers)
Date: 2020-09
New Economics Papers: this item is included in nep-cba, nep-mon and nep-opm
Note: EFG ME
References: Add references at CitEc
Citations: View citations in EconPapers (8)

Published as Sebastián Fanelli & Ludwig Straub, 2021. "A Theory of Foreign Exchange Interventions," The Review of Economic Studies, vol 88(6), pages 2857-2885.

Downloads: (external link)
http://www.nber.org/papers/w27872.pdf (application/pdf)

Related works:
Journal Article: A Theory of Foreign Exchange Interventions (2021)
Working Paper: A Theory of Foreign Exchange Interventions (2020)
Working Paper: A Theory of Foreign Exchange Interventions (2018)
This item may be available elsewhere in EconPapers: Search for items with the same title.

Export reference: BibTeX RIS (EndNote, ProCite, RefMan) HTML/Text

Persistent link: https://EconPapers.repec.org/RePEc:nbr:nberwo:27872

Ordering information: This working paper can be ordered from
http://www.nber.org/papers/w27872

Access Statistics for this paper

More papers in NBER Working Papers from National Bureau of Economic Research, Inc National Bureau of Economic Research, 1050 Massachusetts Avenue Cambridge, MA 02138, U.S.A.. Contact information at EDIRC.
Bibliographic data for series maintained by ().