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Foreign Exchange Reserves as a Tool for Capital Account Management

Jonathan Davis (), Ippei Fujiwara, Kevin Huang () and Jiao Wang

No 352, Globalization Institute Working Papers from Federal Reserve Bank of Dallas

Abstract: Many recent theoretical papers have argued that countries can insulate themselves from volatile world capital flows by using a variable tax on foreign capital as an instrument of monetary policy. But at the same time many empirical papers have argued that only rarely do we observe these cyclical capital taxes used in practice. In this paper we construct a small open economy model where the central bank can engage in sterilized foreign exchange intervention. When private agents can freely buy and sell foreign bonds, sterilized foreign exchange intervention has no effect. But we analytically prove that when private agents cannot freely buy and sell foreign bonds, that is, under acyclical capital controls, optimal sterilized foreign exchange intervention is equivalent to an optimally chosen tax on foreign capital. Numerical simulations of the model show that a variable capital tax is a reasonable approximation for sterilized foreign exchange intervention under the levels of capital controls observed in many emerging markets.

Keywords: small open economy; capital controls; foreign exchange reserves; Central bank (search for similar items in EconPapers)
JEL-codes: E50 E30 F40 (search for similar items in EconPapers)
Pages: 51 pages
Date: 2019-02-05, Revised 2019-02-05
New Economics Papers: this item is included in nep-cba, nep-mac and nep-mon
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Persistent link: https://EconPapers.repec.org/RePEc:fip:feddgw:352

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DOI: 10.24149/gwp352

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