A Theory of Foreign Exchange Interventions

Abstract We study a real small open economy with two key ingredients (1) partial segmentation of home and foreign bond markets (2) pecuniary externality that makes the exchange rate excessively volatile in response to capital flows. Partial implies that, by intervening markets, central bank can affect spread between home- foreign-bond yields. Such interventions allow address externality, but they are also costly, as foreigners make carry trade profits. analytically characterize optimal intervention policy solves this trade-off: leans against wind, stabilizing rate; it involves smooth spreads allows rates jump; (3) partly relies on “forward guidance,” non-zero even after shock has subsided; (4) requires credibility, banks do not intervene without commitment. Finally, we shed light global consequences widespread interventions, using multi-country extension our model. find left themselves, countries over-accumulate reserves, reducing welfare leading inefficiently low world interest rates.