FX Intervention in the New Keynesian Model

Abstract

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

Keywords: Foreign exchange, Central banks and their policies, Central bank reserves; Speculative attack; Portfolio balance model; Equilibrium determinacy; Capital flows; Capital controls; Open Economy New Keynesian Model, Central bank reserves, Speculative attack, Portfolio balance model, Equilibrium determinacy, Capital flows, Capital controls, Open Economy New Keynesian Model, Monetary Policy (Targets, Instruments, and Effects)

JEL Classification: E52, E58, F31