Optimal Foreign Reserve Intervention and Financial Development

Jonathan Davis, Kevin Huang, Zheng Liu and Mark Spiegel

No 2538, Working Papers from Federal Reserve Bank of Dallas

Abstract: We document evidence of a U-shaped relationship between financial development and the adjustments of foreign exchange (FX) reserve holdings in response to a U.S. interest rate increase. Countries with intermediate levels of financial development sell reserves aggressively, while those with low or high development adjust little. Domestic interest rate responses are not systematically related to financial development. A model with borrowing constraints and foreign-currency debt rationalizes these findings: the associated pecuniary externality is maximized at intermediate levels of financial development. Calibrated to match the observed leverage and currency composition, the model reproduces the empirical U-shaped relationship under optimal FX reserve policy, and this relation is robust under a range of conventional interest-rate policy regimes.

Keywords: foreign reserves; financial development; capital flows; optimal policy (search for similar items in EconPapers)
JEL-codes: E52 F32 F38 (search for similar items in EconPapers)
Pages: 38
Date: 2025-11-03
New Economics Papers: this item is included in nep-cba, nep-ifn and nep-mon
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DOI: 10.24149/wp2538

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