Foreign exchange intervention and financial stability
(September 2020, revised October 2025)
Summary
Focus
Managed floats remain the norm in middle-income countries - even among those that have adopted inflation targeting as their monetary policy framework. Moreover, the decision to intervene appears to be increasingly driven by the goal of limiting exchange rate volatility, rather than concerns about competitiveness, the degree of exchange rate pass-through, or the need to build foreign reserves for precautionary reasons. At the same time, intervention in foreign exchange markets has often been highly sterilised, with the goal of avoiding broader macroeconomic effects. However, even when sterilised, intervention can have an impact on macroeconomic fluctuations and systemic financial risks. Research on these issues has been limited, despite greater recognition in recent years of the interactions between macroeconomic stability and financial stability.
Contribution
We study the effects of sterilised foreign exchange market intervention in an open-economy DSGE model with financial frictions and imperfect capital mobility. In the model, the central bank operates a managed float regime and follows a simple foreign exchange intervention rule that relates changes in its stock of foreign reserves to exchange rate movements. It also conducts sterilisation operations by issuing bonds held solely by commercial banks. Owing to economies of scope in managing bank assets, these bonds exhibit cost complementarity with investment loans. The model is parameterised for a middle-income country and is used to study the impact of capital inflows associated with a transitory shock to the world risk-free interest rate. We also consider the case where, when setting intervention and sterilisation policies, the central bank is explicitly concerned not only with maximising household welfare but also with the cost of sterilisation - possibly because it affects perceptions of its independence and credibility – as well as financial stability considerations.
Findings
We find, first, that whether sterilised intervention is expansionary or not depends on the relative strengths of the standard liquidity effect and the bank portfolio effect; the stronger the bank portfolio channel, the more expansionary sterilised intervention can be. Second, when the central bank aims solely to maximise household welfare, the optimal degree of intervention is significantly more aggressive when the central bank can simultaneously choose the degree of sterilisation. In that sense, intervention and sterilisation are complements. However, the presence of the bank portfolio effect creates a trade-off and implies that full sterilisation is not optimal – even when the central bank is also explicitly concerned (in addition to maximizing household welfare) with promoting exchange rate stability or financial stability. By contrast, when economies of scope are absent, the bank portfolio channel no longer operates and full sterilisation is always optimal, and intervention and sterilisation remain complements. Third, when sterilisation costs are accounted for in the central bank's objective function and concern with these costs is sufficiently high, the optimal policy for the central bank is to intervene less and sterilise fully – regardless of whether economies of scope exist. In that sense, there is burden-sharing between instruments, and intervention and sterilisation are now (partial) substitutes. In the absence of the bank portfolio channel, a policy mix that involves less aggressive intervention and full sterilisation is also optimal – even when the central bank is also concerned with financial stability.
Abstract
The effects of sterilized intervention are studied in a model with financial frictions. The central bank operates a managed float and issues sterilization bonds. In contrast with most of the existing literature, these bonds are held only by banks, and are imperfect substitutes to loans. The model is parameterized and used to study optimal policy responses to capital inflows associated with a transitory shock to world interest rates. The results show that sterilized intervention can be expansionary due to a bank portfolio channel and may exacerbate risks to financial stability. Full sterilization is optimal only when that channel is absent. The optimal degree of intervention is more aggressive when the central bank can choose simultaneously the degree of sterilization; in that sense, and conditional on intervention taking place, the instruments are complements. When the central bank's objective function also accounts for the implicit cost of sterilization, and concerns with that cost are sufficiently high, intervention and sterilization can be substitutes–independently of whether exchange rate and financial stability considerations also matter for policymakers.
JEL classification: E32, E58, F41
