Foreign exchange interventions in the New-Keynesian model: Policy, transmission, and welfare

Abstract

The paper introduces foreign exchange interventions (FXIs) into an otherwise standard New-Keynesian small open economy model. It solves for the optimal FXI policy, suggests an implementable policy rule, and studies the transmission mechanism of FXIs. Relying on the portfolio balance channel, deviations from the uncovered interest rate parity (UIP) reflect financial inefficiencies. A policy rule that seeks to stabilize the UIP premium moves the economy toward its optimal allocation, regardless of the type of shocks it faces. Augmenting the rule with foreign reserves smoothing further improves welfare. The paper discusses the conditions under which strict targeting of the UIP premium is optimal. FXIs are transmitted by affecting the UIP premium. Purchasing foreign reserves increases the premium, thereby raising the effective return home agents face and depreciating the domestic currency. Consequently, domestic demand contracts and export expands. The results are robust to a variety of modeling alternatives for the financial sector.