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FX Intervention in the New Keynesian Model
Author(s) -
ALLA ZINEDDINE,
ESPINOZA RAPHAEL A.,
GHOSH ATISH R.
Publication year - 2020
Publication title -
journal of money, credit and banking
Language(s) - English
Resource type - Journals
SCImago Journal Rank - 1.763
H-Index - 108
eISSN - 1538-4616
pISSN - 0022-2879
DOI - 10.1111/jmcb.12683
Subject(s) - economics , new keynesian economics , monetary economics , inflation targeting , monetary policy , risk appetite , open economy , exchange rate , financial market , output gap , foreign exchange market , dynamic stochastic general equilibrium , commit , small open economy , shock (circulatory) , floating exchange rate , finance , risk management , database , computer science , medicine
We develop an open‐economy New Keynesian Model with foreign exchange (FX) intervention in the presence of a financial accelerator and shocks to risk appetite in international capital markets. We obtain closed‐form solutions for optimal monetary and FX intervention policies assuming the central bank cannot commit to future policies, and we compare the solution to that under policy commitment. We show how FX intervention can help reduce the volatility of the exchange rate, of inflation, and of the output gap, thus mitigating welfare losses associated with shocks in the international capital markets. We also show that, when the financial accelerator is strong, there is a risk of indeterminacy (self‐fulfilling currency and inflation movements) although FX intervention can reduce this risk and thus reinforce the credibility of the inflation targeting regime. Model simulations match well the impact of a VIX shock obtained by local projections on a panel of inflation targeting emerging markets.