FX Intervention in the New Keynesian Model

We develop an open‐economy New Keynesian Model with foreign exchange (FX) intervention in the presence of a financial accelerator and shocks to risk appetite in international capital markets. We obtain closed‐form solutions for optimal monetary and FX intervention policies assuming the central bank...

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Bibliographic Details
Published in:Journal of money, credit and banking credit and banking, 2020-10, Vol.52 (7), p.1755-1791
Main Authors: ALLA, ZINEDDINE, ESPINOZA, RAPHAEL A., GHOSH, ATISH R.
Format: Article
Language:English
Subjects:
Analysis
capital flows
Capital market
Capital markets
central bank reserves
Central banks
Credibility
E52
E58
Economic models
equilibrium determinacy
F31
Foreign exchange
Foreign exchange rates
Inflation targeting
Intervention
Keynesian theory
Money
open‐economy New Keynesian Model
portfolio balance model
Projections
Risk reduction
speculative attack
Welfare
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Summary:We develop an open‐economy New Keynesian Model with foreign exchange (FX) intervention in the presence of a financial accelerator and shocks to risk appetite in international capital markets. We obtain closed‐form solutions for optimal monetary and FX intervention policies assuming the central bank cannot commit to future policies, and we compare the solution to that under policy commitment. We show how FX intervention can help reduce the volatility of the exchange rate, of inflation, and of the output gap, thus mitigating welfare losses associated with shocks in the international capital markets. We also show that, when the financial accelerator is strong, there is a risk of indeterminacy (self‐fulfilling currency and inflation movements) although FX intervention can reduce this risk and thus reinforce the credibility of the inflation targeting regime. Model simulations match well the impact of a VIX shock obtained by local projections on a panel of inflation targeting emerging markets.
ISSN:0022-2879
1538-4616
DOI:10.1111/jmcb.12683