FX Intervention in the New Keynesian Model

• Author: ZINEDDINE ALLA,RAPHAEL A. ESPINOZA,ATISH R. GHOSH
• Date: 01 October 2020
• Published date: 01 October 2020
• DOI: http://doi.org/10.1111/jmcb.12683

DOI: 10.1111/jmcb.12683

ZINEDDINE ALLA

RAPHAEL A. ESPINOZA

ATISH R. GHOSH

FX Intervention in the New Keynesian Model

Wedevelop 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 howFX 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 cred-

ibility 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.

JEL codes: E52, E58, F31

Keywords: central bank reserves, capital flows, equilibrium determinacy,

open-economy New Keynesian Model, portfolio balance model,

speculative attack.

DESPITE THE MOVE TOWARD GREATER exchange rate flexibility

over the past 30 years, many central banks—including some with inflation targeting

frameworks—seem to havetwin objectives of price stability and (at least some degree

We are grateful for the comments and suggestions from Suman Basu, Olivier Blanchard, Paolo Cav-

allino, Nicolas Coeurdacier, Emmanuel Farhi, Federico Grinberg, Philippe Martin, Helene Rey, Lars

Svensson, Pablo Winant, Felipe Zanna, and from two anonymousreferees as well as seminar participants

at the International Monetary Fund (IMF) and at the Bank of England. The views expressed in this paper

are solely those of the authors and do not represent those of the IMF or IMF policy.

ZINEDDINE ALLA is at Sciences Po,Paris (E-mail: zineddine.alla@gmail.com). RAPHAEL A. ESPINOZA is a

Deputy Division Chief at the International Monetary Fund (E-mail: respinoza@imf.org). ATISHR. GHOSH

is a Deputy Director at the International Monetary Fund (E-mail: aghosh@imf.org).

Received March 27, 2018; and accepted in revised form June 4, 2019.

Journal of Money, Credit and Banking, Vol. 52, No. 7 (October 2020)

C

2019 The Ohio State University

The International Monetary Fund retains copyright and all other rights in the manuscript of

this article as submitted for publication.

1756 :MONEY,CREDIT AND BANKING

of) exchange rate stability.1The principal instruments at their disposal are the policy

interest rate and sterilized intervention in the foreign exchange (FX) market.2But

in the canonical New Keynesian Model (e.g., Gali and Monacelli 2005), the policy

interest rate suffices for stability because the two objectives of stable inflation and

a zero output gap coincide (the “divine coincidence”): there is no exchange rate

objective, and therefore no need for FX intervention. Our purpose in this paper is

to examine whether shocks (e.g., “risk-on/risk-off” episodes) in international capital

markets can give rise to a rationale for sterilized intervention, and to analyze how FX

intervention affects the credibility of an inflation targeting regime.

Our framework, building on the canonical New Keynesian Model, incorporates

three key features. First, the existence of shocks in international capital markets that

result in variations in the cost of capital to the economy. Second, financial frictions

in international capital markets that break uncovered interest rate parity (UIP), and

render sterilized intervention effective through a portfolio balance channel. Third, a

working capital requirement for firms’ production that amplifies the effects of the

capital market shocks on the real economy.3

The issues we examine are of salience to both emerging market and advanced

economies. As is well known, many emerging market central banks exhibit a “fear of

floating” (Calvo and Reinhart 2002), and will often respond to capital inflow surges

and sudden stops using monetary policy and FX intervention (see also Fratzscher

et al. 2019). Switzerland provides an advanced economy example of the use of

FX intervention. As the Euro crisis deepened in 2011, leading to large financial

flows into Switzerland, the Swiss National Bank (SNB) announced a ceiling for

the franc, backing it with aggressive intervention. Despite some initial success in

mitigating capital inflows and stabilizing the exchange rate, there were concerns that

the market might be anticipating a revaluation,and that such expectations would result

in a self-fulfilling strengthening of the currency as the ballooning reserves became

unsustainably costly to hold (in effect, a “reverse” speculative attack). Recognizing

that one policy instrument may not suffice to contain speculative flows, the SNB cut

its policy rate from −0.25% to −0.75% in January 2015.

The framework we develop is well suited to analyzing optimal policy in the face

of shocks in international capital markets, which are particularly important for small

open economies. As Itskhoki and Mukhin (2017) show, moreover, they are also

crucial to understanding the major exchange rate puzzles documented in the inter-

national finance literature. We begin by showing that these shocks break the divine

coincidence and make sterilized intervention a valuable addition to the central bank’s

1. According to the IMF classification, around one-third of all countries either de jure or de facto

manage their exchange rate.

2. Sterilized intervention consists of the central bank purchasing or selling foreign currency-

denominated assets with corresponding sales or purchases of domestic currency assets in order to leave

the money supply unchanged. If FX intervention is not sterilized, then it does not constitute a separate

instrument from monetary policy.

3. See Farhi and Werning (2014) or Woodford (2012) for models in which financial frictions justify

the use of capital controls or unconventional policies. In practice, FX intervention is the most commonly

used tool after the policy interest rate.

ZINEDDINE ALLA, RAPHAEL A. ESPINOZA, AND ATISHR. GHOSH :1757

policy toolkit. We then show that under discretionary policies, the availability of FX

intervention helps reduce the “stabilization bias” associated with the central bank’s

lack of commitment (Clarida, Gali, and Gertler 1999), where the benefit depends on

the degree of openness of the economy. Finally, we show how the availability of FX

intervention as policy instrument can also reduce the zone of equilibrium indetermi-

nacy (which we interpret as the zone where speculative attacks are possible) thereby

contributing to macro-economic stability and to the credibility of inflation targeting.

The paper thus contributes to the literature on the desirability of FX intervention for

inflation-targeting central banks, in which Ghosh, Ostry, and Chamon (2016), and

Blanchard et al. (2016) are recent examples.

Beyond developing a tractable model of FX intervention in a New Keynesian

Model, where sterilized intervention works through a portfolio balance channel, our

contribution is threefold. First, we derive closed-form solutions for the optimal policy

of the central bank under discretion and we compare our results to those obtained

under commitment, allowing us to analyze the costs of the lack of credibility. Our

results show that FX intervention can “lean against the wind” and can help offset

changes in investors’ risk appetite. However, since FX intervention carries welfare

costs (because it affects the international asset position of the economy), the central

bank only partially offsets these shocks. We also show that the welfare benefits of

using FX intervention after a 5% risk premium shock, (which would depreciate the

exchange rate by 10%) are sizeable, at around 0.4% of permanent consumption for

a standard calibration of the model. The comparison with the commitment solution

shows that a commitment technology would allow the central bank to achieve a

smaller deviation of inflation on impact and lower output volatility as inflation is

better anchored by the promise of stable future inflation. However, the welfare gains

from commitment are an order of magnitude smaller than the welfare gains obtained

from being able to use FX intervention on top of monetary policy.

Second, we show the importance of the financial accelerator for equilibrium in-

determinacy, and establish that FX intervention can be useful in limiting the risk of

self-fulfilling, “expectational,” bubbles in the exchange rate. In particular, we show

that a central bank that is more willing to use both FX intervention and conventional

interest rate policy is less likely to face the risk of indeterminacy.

Third, we establish the relevance of our model to emerging markets, as we show

that our simulations replicate well the macro-economic dynamics observed after

shocks to the VIX.

Our paper is related to the literature on third-generation speculative attacks and

sudden stops (Krugman 1999, Aghion, Bacchetta, and Banerjee 2000, Mendoza

2010). However, the New Keynesian modeling strategy we adopt makes our paper

closest to Farhi and Werning (2014), who show how capital controls are useful

instruments in economies hit by shocks to capital flows, and to Cavallino (2019),

who includes Gabaix and Maggiori (2015)’s microfoundation of FX intervention in

a New Keynesian Model solved under commitment.

The paper is organized as follows. Section 1 reviews the literature. Section 2

presents the open-economy model, in particular the mechanics of FX intervention,