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Foreign exchange reserves as a tool for capital account management

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

No 19-00004, Vanderbilt University Department of Economics Working Papers from Vanderbilt University Department of Economics

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 present a small open economy framework 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: Central bank; Small open economy; foreign exchange reserves; capital controls (search for similar items in EconPapers)
JEL-codes: E5 F4 (search for similar items in EconPapers)
Date: 2019-03-25
New Economics Papers: this item is included in nep-acc, nep-mac and nep-mon
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