The portfolio balance channel of capital flows and foreign exchange intervention in a small open economy

Carlos Montoro, Marco Ortiz

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Resumen

In this paper we extend a new Keynesian small open economy model with a segmented financial market featuring financial intermediaries as in Itskhoki and Mukhin (2021). The former ingredients generate deviations from the uncovered interest parity (UIP) condition. More precisely, the portfolio decisions of financial intermediaries add a time varying risk-premium element to the traditional UIP that depends on foreign exchange intervention (FXI) and FX orders by foreign investors. We present closed form solutions for optimal FXI. Additionally, we analyse the effectiveness of different FXI rules commonly discussed across policymakers. Our findings are as follows: (i) FXI rules can improve welfare in presence of the portfolio balance channel; (ii) under a general parametrization, fundamental shocks can trigger an inefficient path for the exchange rate; (iii) optimal policy calls for leaning against the wind to portfolio flow shocks and leaning with the wind to fundamental shocks; (iv) the effectiveness of FXI rules depends on the frequency and nature of the shocks and parameters characterizing the economy.

Idioma originalInglés
Número de artículo102825
PublicaciónJournal of International Money and Finance
Volumen133
DOI
EstadoPublicada - may. 2023

Nota bibliográfica

Funding Information:
☆ An earlier version of this paper circulated under the title “Foreign Exchange Intervention and Monetary Policy Design: a Market Microstructure Analysis”. We are grateful to Lawrence Christiano, Paolo Vitale, Wouter J. Den Haan, Muhammad Ali Nasir, Paul Castillo, Fernando Perez, Freddy Pinzón and Ken Miyahara as well as the participants of the BIS 4th CCA conference, the Northwestern University, Federal Reserve of Atlanta, Bank of Canada and BCRP seminar, the 3rd Financial Economics Meeting, LACEA-LAMES 2022 and the 2022 CEMLA-FRBNY-ECB conference. We also thank the Editor-in-Chief, the Guest Editor and the referees for suggesting substantial improvements. We are grateful to Gerardo Herrera for his excellent research assistance. This research did not receive any specific grant from funding agencies in the public, commercial, or not-for-profit sectors.

Publisher Copyright:
© 2023 Elsevier Ltd

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