Exchange Rate Determination and Optimal FXI Policy: The Role of Portfolio and Liquidity Shocks

Description

This paper develops a model of incomplete and segmented financial markets to examine the determination of the exchange rate. We analyze how financial intermediaries price in the costs associated with holding long or short positions in foreign exchange and trading away liquid assets for illiquid ones, leading to deviations from uncovered interest rate parity for portfolio and liquidity motives. We demonstrate that the importance of these motives depends on the effects of portfolio shocks and the liquidity risks associated to deposit creation in each currency. We use this framework to study the effects of foreign exchange intervention (FXI) policy with both spot and derivatives, where only the former are effective in the case of foreign liquidity shortages.

Period	1 Dec 2023