Foreign Exchange Reserves as a Tool for Capital Account Management

51 Pages Posted: 28 Mar 2019

See all articles by Scott Davis

Scott Davis

Federal Reserve Banks - Federal Reserve Bank of Dallas

Ippei Fujiwara

Australian National University (ANU) - Crawford School of Public Policy

Kevin X. D. Huang

Federal Reserve Bank of Philadelphia; Vanderbilt University - College of Arts and Science - Department of Economics

Jiao Wang

University of Melbourne - Melbourne Institute of Applied Economic and Social Research

Date Written: 2019-02-05

Abstract

Many recent theoretical papers have argued that countries can insulate themselves from volatile world capital flows by using a variable tax on foreign capital as an instrument of monetary policy. But at the same time many empirical papers have argued that only rarely do we observe these cyclical capital taxes used in practice. In this paper we construct a small open economy model where the central bank can engage in sterilized foreign exchange intervention. When private agents can freely buy and sell foreign bonds, sterilized foreign exchange intervention has no effect. But we analytically prove that when private agents cannot freely buy and sell foreign bonds, that is, under acyclical capital controls, optimal sterilized foreign exchange intervention is equivalent to an optimally chosen tax on foreign capital. Numerical simulations of the model show that a variable capital tax is a reasonable approximation for sterilized foreign exchange intervention under the levels of capital controls observed in many emerging markets.

Keywords: Central bank, small open economy, foreign exchange reserves, capital controls

JEL Classification: E30, E50, F40

Suggested Citation

Davis, Scott and Fujiwara, Ippei and Huang, Kevin X. D. and Wang, Jiao, Foreign Exchange Reserves as a Tool for Capital Account Management (2019-02-05). Globalization and Monetary Policy Institute Working Paper No. 352. Available at SSRN: https://ssrn.com/abstract=3361325 or http://dx.doi.org/10.24149/gwp352

Scott Davis (Contact Author)

Federal Reserve Banks - Federal Reserve Bank of Dallas ( email )

2200 North Pearl Street
PO Box 655906
Dallas, TX 75265-5906
United States

Ippei Fujiwara

Australian National University (ANU) - Crawford School of Public Policy ( email )

ANU College of Asia and the Pacific
J.G. Crawford Building #132 Lennox Crossing
Canberra, Australian Capital Territory 0200
Australia

Kevin X. D. Huang

Federal Reserve Bank of Philadelphia ( email )

Ten Independence Mall
Philadelphia, PA 19106-1574
United States

Vanderbilt University - College of Arts and Science - Department of Economics ( email )

Box 1819 Station B
Nashville, TN 37235
United States

Jiao Wang

University of Melbourne - Melbourne Institute of Applied Economic and Social Research ( email )

Level 5, FBE Building, 111 Barry Street
Parkville, Victoria 3010
Australia

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