Optimal FX Interventions with Limited Reserves

Marcin Kolasa, Oliver Vogt and Pawel Zabczyk

No 2025/261, IMF Working Papers from International Monetary Fund

Abstract: We investigate the optimal time-consistent use of foreign exchange interventions (FXI) in a small open economy model driven by endowment and portfolio flow shocks, with endogenous FX market depth and a lower bound constraint on FX reserves. In a competitive equilibrium, large capital flows increase conditional exchange rate volatility and make FX markets more shallow. Unlike in the unconstrained case, the central bank's optimal interventions are not solely targeted at offsetting inefficient fluctuations in the UIP premium but also incorporate a forward-looking element due to the risk of depleting reserves. We show that this environment engenders optimal time-consistent FXI policy that is state-dependent. FX sales are more effective than FX purchases, and the policy may respond less or more than one-for-one to capital outflows, depending on their size and the economy's net foreign asset position. Adopting the policy delivers sizable welfare gains, significantly exceeding those from a simple rule directed at stabilizing current capital flows, but only if the initial level of FX reserves is sufficiently far from its effective lower bound.

Keywords: Capital Flows; FX Interventions; Lower Bound on FX Reserves; Time-Consistent Policy; FX intervention; IMF working papers; capital flow; FX sale; FX purchase; Exchange rates; Currency markets; Currencies; Interest rate parity; Global (search for similar items in EconPapers)
Pages: 56
Date: 2025-12-12
New Economics Papers: this item is included in nep-cba and nep-mon
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