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 levels adjust little. A model with borrowing constraints and foreign-currency debt rationalizes these findings. Optimal FX reserve policy faces a tradeoff between the rate of return on capital outflows and a pecuniary externality linked to foreign currency debt in the borrowing constraints. This pecuniary externality is maximized at intermediate levels of financial development.

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, Revised 2026-08-19
New Economics Papers: this item is included in nep-cba, nep-fdg, nep-ifn, nep-mon and nep-opm
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DOI: 10.24149/wp2538r1

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