Foreign exchange intervention and monetary policy design: a market microstructure analysis
In this paper we extend a new Keynesian open economy model to include risk-averse FX dealers and FX intervention by the monetary authority. These ingredients generate deviations from the uncovered interest parity (UIP) condition. More precisely, in this setup portfolio decisions of the dealers add endogenously a time variant risk-premium element to the traditional UIP that depends on FX intervention by the central bank and FX orders by foreign investors. We analyse the effectiveness of different strategies of FX intervention (e.g.,unanticipated operations or via a preannounced rule) to affect the volatility of the exchange rate and the transmission mechanism of the interest rate. Our findings are as follows: (i) FX intervention has a strong interaction with monetary policy in general equilibrium; (ii) FX intervention rules can have stronger stabilisation power than discretion in response to shocks because they exploit the expectations channel; and (iii) there are some trade-offs in the use of FX intervention, since it can help to isolate the economy from external financial shocks, but it prevents some necessary adjustments on the exchange rate as a response to nominal and real external shocks.
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