Sudden Stops and Optimal Foreign Exchange Intervention

56 Pages Posted: 13 Nov 2020

See all articles by Scott Davis

Scott Davis

Federal Reserve Banks - Federal Reserve Bank of Dallas

Michael Devereux

Schroders Investment Management

Changhua Yu

Peking University

Multiple version iconThere are 2 versions of this paper

Date Written: November, 2020

Abstract

This paper shows how foreign exchange intervention can be used to avoid a sudden stop in capital flows in a small open emerging market economy. The model is based around the concept of an under-borrowing equilibrium defined by Schmitt-Grohe and Uribe (2020). With a low elasticity of substitution between traded and non-traded goods, real exchange rate depreciation may generate a precipitous drop in aggregate demand and a tightening of borrowing constraints, leading to an equilibrium with an inefficiently low level of borrowing. The central bank can preempt this deleveraging cycle through foreign exchange intervention. Intervention is effective due to frictions in private international financial intermediation. Reserve accumulation has ex ante benefits by reducing the risk of a sudden stop, while intervention has ex-post benefits by limiting inefficient deleveraging. But intervention itself faces constraints. When the central bank's stock of reserves is low, even foreign exchange intervention cannot prevent a sudden stop.

JEL Classification: E50, E30, F40

Suggested Citation

Davis, Scott and Devereux, Michael and Yu, Changhua, Sudden Stops and Optimal Foreign Exchange Intervention (November, 2020). Globalization and Monetary Policy Institute Working Paper No. 405, Available at SSRN: https://ssrn.com/abstract=3729668 or http://dx.doi.org/10.24149/gwp405

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

Michael Devereux

Schroders Investment Management ( email )

31 Gresham Street
London, EC2V 7QA
United Kingdom

Changhua Yu

Peking University ( email )

China Center for Economic Research
National School of Development, Peking University
Beijing, 100871
China

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