Abstract |
In this paper we extend a new Keynesian open economy model to include risk-averse
FX dealers and FX intervention by the monetary authority. These ingredients generate
deviations from the uncovered interest parity (UIP) condition. More precisely, in this setup
portfolio decisions of the dealers add endogenously a time variant risk-premium element to
the traditional UIP that depends on FX intervention by the central bank and FX orders by
foreign investors. We analyse the effectiveness of different strategies of FX intervention (e.g.,
unanticipated operations or via a preannounced rule) to affect the volatility of the exchange
rate and the transmission mechanism of the interest rate. Our findings are as follows: (i)
FX intervention has a strong interaction with monetary policy in general equilibrium; (ii)
FX intervention rules can have stronger stabilisation power than discretion in response to
shocks because they exploit the expectations channel; and (iii) there are some trade-offs in
the use of FX intervention, since it can help to isolate the economy from external financial
shocks, but it prevents some necessary adjustments on the exchange rate as a response to
nominal and real external shocks. |