Tolerance of Flexibility: Foreign Exchange Intervention and Managed Floating Redux

39 Pages Posted: 13 May 2019

See all articles by Dong Lu

Dong Lu

Renmin University of China

Hang Zhou

University of International Business and Economics (UIBE) - School of Banking and Finance

Date Written: April 30, 2019

Abstract

In recent decades, there has been a rising share of countries with limited exchange rate flexibility (Ilzetzki et al., 2019), and foreign exchange (FX) intervention is commonly used among emerging market economies. Yet, the positive and normative implications of central banks' FX intervention and managed floating regime remain largely unexplored. Focusing on the case of China, we provide new empirical patterns of China's exchange rate policy after the global financial crisis. We find strong evidence that the central bank's FX intervention policy is nonlinear: it intervenes in heavily when the RMB exchange rate deviates from its long run trend by a large margin and otherwise it keeps inactive. Further, the central bank responds asymmetrically toward exchange rate depreciation and appreciation, with a higher tolerance for depreciation. To assess the policy effects of managed floating, we build a dynamic stochastic general equilibrium (DSGE) model embedded with an occasional binding constraint on the exchange rate. Compared to a fully floating exchange rate regime, FX intervention leads to a higher volatility in major variables on facing a foreign interest rate shock. Moreover, the exchange rate deviation constraint binds longer when the capital restriction is removed, which indicates that capital controls and FX policies are complements in terms of restricting exchange rate fluctuations.

Keywords: Managed Float, Nonlinear FX Intervention, Occasional Binding Constraints, Capital Controls, Monetary Policy, China’s Currency, RMB

JEL Classification: F31, F32, F33, F38

Suggested Citation

Lu, Dong and Zhou, Hang, Tolerance of Flexibility: Foreign Exchange Intervention and Managed Floating Redux (April 30, 2019). Available at SSRN: https://ssrn.com/abstract=3380122 or http://dx.doi.org/10.2139/ssrn.3380122

Dong Lu

Renmin University of China ( email )

Room B906
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Hang Zhou (Contact Author)

University of International Business and Economics (UIBE) - School of Banking and Finance ( email )

No.10, Huixindong Street
Chaoyang District
Beijing, 100029
China

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