The paper introduces foreign exchange interventions (FXIs) to an otherwise standard new-Keynesian small open economy model. The paper studies the transmission mechanism of FXIs, solves for the optimal policy, suggests an implementable policy rule, and evaluates the welfare implications of different policies.

Relying on the portfolio balance channel, a purchase of foreign reserves crowds out private holdings of foreign assets, thereby raising the UIP premium and the effective real return domestic agents face. As a result, a purchase of foreign reserves contracts domestic demand. At the same time, it depreciates the value of the domestic currency, which raises the price of foreign goods relative to domestic goods, thereby expanding foreign demand for home exports and contracting domestic imports. The effect on production depends on the wealth effect on labor supply. Optimal FXIs completely insulate the economy from the effect of financial shocks, such as capital flows and risk premium shocks. A policy rule that aims at stabilizing the UIP premium brings the economy close to its optimal allocation, regardless of the source of the shocks. The paper discusses the conditions under which strict targeting of the UIP premium is optimal. Calibrating the model to the Israeli economy, lifetime welfare gains from following optimal FXI policy, relative to maintaining a fixed level of foreign reserves, amount to 2.4% of annual steady state consumption.

The results are robust to a variety of microstructures of the financial sector suggested in recent literature.


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