FX Intervention in the New Keynesian Model

By Zineddine Alla, Raphael A Espinoza, Atish R. Ghosh

September 29, 2017

Preview Citation

Format: Chicago

Zineddine Alla, Raphael A Espinoza, and Atish R. Ghosh FX Intervention in the New Keynesian Model, (USA: International Monetary Fund, 2017) accessed December 22, 2024

Disclaimer: IMF Working Papers describe research in progress by the author(s) and are published to elicit comments and to encourage debate. The views expressed in IMF Working Papers are those of the author(s) and do not necessarily represent the views of the IMF, its Executive Board, or IMF management.

Summary

We develop an open economy New Keynesian Model with foreign exchange intervention in the presence of a financial accelerator mechanism. We obtain closed-form solutions for the optimal interest rate policy and FX intervention under discretionary policy, in the face of shocks to risk appetite in international capital markets. The solution shows that FX intervention can help reduce the volatility of the economy and mitigate the welfare losses associated with such shocks. We also show that, when the financial accelerator is strong, the risk of multiple equilibria (self-fulfilling currency and inflation movements) is high. We determine the conditions under which indeterminacy can occur and highlight how the use of FX intervention reinforces the central bank’s credibility and limits the risk of multiple equilibria.

Subject: Consumption, Exchange rates, Foreign exchange, Inflation, National accounts, Prices, Return on investment

Keywords: Capital controls, Capital flows, Central bank, Central bank reserves, Consumption, Equilibrium determinacy, Exchange rates, FX intervention, Global, Inflation, Open economy, Open Economy New Keynesian Model., Portfolio balance model, Return on investment, Risk premium, Risk premium shock, Speculative attack, Sterilized foreign exchange intervention, Terms of trade, Working capital, WP

Publication Details

Pages:

39
Volume:

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DOI:

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Issue:

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Series:

Working Paper No. 2017/207
Stock No:

WPIEA2017207
ISBN:

9781484320617
ISSN:

1018-5941

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