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A Theory of Foreign Exchange Interventions

Sebastian Fanelli () and Ludwig Straub
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Ludwig Straub: MIT

No 1270, 2018 Meeting Papers from Society for Economic Dynamics

Abstract: This paper develops a theory of foreign exchange interventions in a small open economy with limited capital mobility. Home and foreign bond markets are segmented and intermediaries are limited in their capacity to arbitrage across markets. As a result, the central bank can implement nonzero spreads by managing its portfolio. Crucially, spreads are inherently costly, over and above the standard costs from distorting households’ consumption profiles. The extra term is given by the carry-trade profits of foreign intermediaries, is convex in the spread—as more foreign intermediaries become active carry traders—and increasing in the openness of the capital account—as foreign intermediaries find it easier to take larger positions. Optimal interventions balance these costs with terms of trade benefits. We show that they lean against the wind of global capital flows to avoid excessive currency appreciation. Due to the convexity of the costs, interventions should be small and spread out, relying on credible promises (forward guidance) of future interventions. By contrast, excessive smoothing of the exchange rate path may create large spreads, inviting costly speculation. Finally, in a multi-country extension of our model, we find that the decentralized equilibrium features too much reserve accumulation and too low world interest rates, highlighting the importance of policy coordination.

New Economics Papers: this item is included in nep-dge, nep-ifn and nep-opm
Date: 2018
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