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Foreign exchange intervention and financial stability

Pierre-Richard Agénor (), Timothy Jackson and Luiz Awazu Pereira da Silva ()

No 889, BIS Working Papers from Bank for International Settlements

Abstract: This paper studies the effects of sterilized foreign exchange market intervention in a model with financial frictions and imperfect capital mobility. The central bank operates a managed float regime and issues sterilization bonds that are imperfect substitutes (as a result of economies of scope) to investment loans in bank portfolios. The model is parameterized and used to study the macroeconomic effects of, and policy responses to, capital inflows associated with a transitory shock to world interest rates. The results show that sterilized intervention can be expansionary through a bank portfolio effect and may increase volatility and financial stability risks. Full sterilization is optimal only when the bank portfolio effect is absent. The optimal degree of intervention is more aggressive when the central bank can choose simultaneously the degree of sterilization; in that sense, the instruments are complements. When the central bank's objective function depends on the cost of sterilization, and concerns with that cost are sufficiently high, intervention and sterilization can be substitutes---independently of whether exchange rate and financial stability considerations also matter.

JEL-codes: E32 E58 F41 (search for similar items in EconPapers)
Pages: 57 pages
Date: 2020-09
New Economics Papers: this item is included in nep-cba, nep-dge, nep-mac and nep-mon
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