Journal article

Foreign exchange reserves as a tool for capital account management

JS Davis, I Fujiwara, KXD Huang, J Wang

Journal of Monetary Economics | Elsevier | Published : 2021


Recent theoretical papers argue 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 empirical papers argue that we rarely observe these cyclical capital flow taxes used in practice. We construct a small open economy model where the central bank engages in sterilized foreign exchange intervention. When private agents freely trade foreign bonds, sterilized intervention has no effect. But we prove that when frictions prevent the free trade in foreign bonds, optimal sterilized foreign exchange intervention is equivalent to an optimal tax on foreign capital. The model is then calibrated to mat..

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Funding Acknowledgements

We thank the editor, Yuriy Gorodnichenko, the associate editor, Vivian Yue, and an anonymous referee. We have also benefited from conversations with Marvin Goodfriend, Zheng Liu, Enrique Mendoza, Andrew Rose, Mark Spiegel, Martin Uribe, Yi Wen, and seminar participants at the Federal Reserve Banks of Dallas and Boston and Osaka University, the China Meeting of the Econometric Society, and the Shanghai Macro Workshop for many helpful comments and suggestions. Fujiwara acknowledges the financial support from JSPS KAKENHI Grant-in-Aid for Scientific Research (A) Grant Number 15H01939 and 18H03638. The views presented here are those of the authors and do not necessarily represent the views of the Federal Reserve Bank of Dallas or the Federal Reserve System.