Skip to main content
SpringerLink
Log in

Modeling Sterilized Interventions and Balance Sheet Effects of Monetary Policy in a New-Keynesian Framework

  • Research Article
  • Published:
Open Economies Review Aims and scope Submit manuscript

Abstract

We study a wide range of hybrid inflation–targeting (IT) and managed exchange rate regimes, analyzing their implications for inflation, output and the exchange rate. To this end, we develop an open economy new–Keynesian model featuring sterilized interventions as an additional central bank instrument operating alongside the Taylor rule and affecting the economy through portfolio balance effects in the financial sector. We find that there can be advantages, from a welfare perspective, to combining IT with some degree of exchange rate management via FX interventions. Unlike “pure” IT or exchange rate management via interest rates, FX interventions can help insulate the economy against certain shocks, especially shocks to international financial conditions. However, managing the exchange rate through interventions may also hinder necessary exchange rate adjustments, e.g., in the presence of terms of trade shocks.

This is a preview of subscription content, log in via an institution to check access.

Access this article

Log in via an institution

Price excludes VAT (USA)
Tax calculation will be finalised during checkout.

Instant access to the full article PDF.

Institutional subscriptions

Fig. 1
Fig. 2
Fig. 3
Fig. 4
Fig. 5
Fig. 6

Similar content being viewed by others

Notes

  1. 1 See Curdia and Woodford (2011), and Gertler and Karadi (2011) for a modelling of the credit policy of the central bank.

  2. 2 Even central banks in several developed countries (including Switzerland, Australia, and Israel, among others) embarked on regular interventions, as a part of their efforts to stabilize domestic financial conditions. See Reserve (Reserve Bank of Australia 2008), (Bank of Israel 2009), and (Swiss National Bank 2008).

  3. 3 Uppercase variables denote nominal variables in levels, while lowercase variables denote real variables or nominal rates such as inflation and interest rates. A ’hat’ \((\hat {*})\) denotes a log-deviation from the steady state.

  4. 5A properly defined steady state requires perfect consistency between nominal targets. In the absence of a trend in the real exchange rate, so that the equilibrium real exchange rate is\(\overline {q}\), π T and S T must satisfy the following identity: \(log(S^{T}/S^{T}_{-1})=log(\overline {q}/\overline {q})+log((P/P_{-1})^{T})-log({(P^{*}/P^{*}_{-1})}^{T})=\uppi ^{T}-\uppi ^{*T}.\)

  5. 5 The interest rate reflects domestic shocks only to the extent that the country’s external risk premium responds endogenously to these shocks, e.g., by being sensitive to movements in the current account or in the country’s net foreign asset position.

  6. 6Blanchard et al. (2005) propose a revival of the portfolio approach, however.

  7. 7 We chose to use as simplistic balance sheets as allowed by the requirements of our analysis. In doing so, we disregarded many sometimes-important practical aspects, sacrificing realism. For instance, our financial sector runs an unhedged short position in FX, which would not be allowed by prudential regulation. Our households are net borrowers, rather than savers. And we assume a central bank with a negative net domestic asset position, which is a necessary condition if the central bank holds a stock of foreign reserves but does not issue reserve money (in a cashless world). However, our exposition can be generalized. For instance, firms borrowing from the financial sector can be added to make households net savers. The financial sector can run separate balance sheets in FX and local currencies, thus assuming partial financial dollarization. And introducing reserve money can make the net domestic asset position of the central bank positive. For the purposes of our exposition these are unnecessary complications, though. What matters is that sterilized interventions affect the degree of exchange rate risk faced by the domestic financial system, which does not depend on whether the central bank’s net domestic assets are positive or negative. In a separate appendix (available upon request) we show how reserve money can be added, but leave the analysis of interventions in the context of financial dollarization for future work.

  8. 8 We analyze the balance sheet operations required to implement interest rate policy in a separate appendix (available upon request).This asymmetry reflects central bank practices as well as some underlying economics. Exchange rate targets are analogous to targets on long-term interest rates, in that both imply setting prices for assets that yield capital gains or losses if prices change and hence that are more subject to speculative attacks than overnight rates (see (Woodford 2005) for the case of long rates). This implies that achieving these targets exactly, as represented by an infinite ω in (3) may strain central bank balance sheets and be difficult to achieve. We return to this point later. For current purposes, however, the implication is that many central banks conduct quantity–based operations aimed at achieving targets for the exchange rate without necessarily hitting the targets exactly. Similarly, recent efforts at “quantitative easing’ in developed countries aim to influence but not precisely target long interest rates.

  9. 9 In the working paper version of this paper, we studied whether such a relation could be derived from a simple portfolio allocation problem as well as a a bank cost function that depended on banks’ holdings of central bank securities and loans. Although these setups went some way toward generating risk premia that was sensitive to holding of various assets, their functional forms differed considerably from the simple relations presented in the text.

  10. 10 If the premium depends on the total stock of domestic assets, then the intervention rule in (3) can be specified in terms of L+O, and the model–based analysis would be the same.

  11. 11 We set l o g(Ω L ) to zero for the sake of simplicity.

  12. 12 See Krugman (1979).

  13. 13 The literature on the impossible trinity is time-honored and extensively large. See Obstfeld, Shambaugh and Taylor (2004) for a historical perspective.

References

  • Adler G, Tovar C (2011) Foreign exchange market intervention: how good a defense against appreciation winds? IMF Working Paper 11/165. (Washington: International Monetary Fund)

  • Backus D, Kehoe P (1989) On the denomination of government debt. J Monet Econ 23:359–376

    Article  Google Scholar 

  • Batini N, Levine P, Pearlman J (2007) International Dimensions of Monetary Policy. In: Jordi G, Gertler MJ (eds) Monetary Rules in Emerging Economies with Financial Market Imperfections. University of Chicago Press, Chicago

    Google Scholar 

  • Bank of Israel (2009) Inflation Report, January-March. Jerusalem: Bank of Israel

  • BIS (2005) Foreign exchange market intervention in emerging markets: motives, techniques and implications, BIS papers No. 24, basel: Bank for International Settlements

  • Berganza JC, Broto C (2011) Flexible inflation targets, forex interventions and exchange rate volatility in emerging countries, Banco de Espaa Working Papers No.1105 (Madrid: Banco de Espana)

  • Blanchard O, Giavazzi F, Sa F (2005) International Investors, the U.S. Current Account, and the Dollar. Brookings Pap Econ Act 36 (1): 1–66

    Article  Google Scholar 

  • Canales-Kriljenko JI (2003) Foreign exchange intervention in developing and transition economies: results of a survey, IMF Working Paper 03/95 (Washington: International Monetary Fund)

  • Canzoneri M, Cumby R, Diba B (2013) Addressing international empirical puzzles: the liquidity of bonds. Open Econ Rev 24 (2):197–215

    Article  Google Scholar 

  • Cavusoglu N (2010) Exchange rates and the effectiveness of actual and oral official interventions: a survey on findings, issues and policy implications. Global Econ J 10 (4)

  • Curdia V, Woodford M (2011) The central-bank balance sheet as an instrument of monetary policy. J Monet Econ 58:54–79

    Article  Google Scholar 

  • Domac I, Mendoza A (2004) Is there room for foreign exchange interventions under an inflation targeting framework? Evidence from Mexico and Turkey, policy research working paper No. 3288 (Washington: World Bank)

  • Dominguez KM, Frankel JA (1993) Does foreign-exchange intervention matter? The portfolio effect. Am Econ Rev 83 (5): 1356–1369

    Google Scholar 

  • Dornbusch R (1976) Expectations and exchange rate dynamics. J Pol Econ 84(6):1161–1176

    Article  Google Scholar 

  • Egert B (2007) Central bank interventions, communication and interest rate policy in emerging European economies. J Comp Econ 35(2): 387–413

    Article  Google Scholar 

  • Fatum R, Hutchison MM (2003) Is sterilized foreign exchange intervention effective after all? An event study approach. Econ J 113: 390–411

    Article  Google Scholar 

  • Fatum R, Hutchison MM (2010) Evaluating foreign exchange market intervention: self-selection, counterfactuals and average treatment effects. J Int Money Financ 29(3): 570–584

    Article  Google Scholar 

  • Friedman M (1953) The case for flexible exchange rates, in essays in positive economics. University of Chicago Press, Chicago

    Google Scholar 

  • Gabaix X, Maggiori M (2014) International liquidity and exchange rate dynamics. NBER Work Papers 19854

  • Gersl A, Holub T (2006) Foreign exchange interventions under inflation targeting: the Czech experience. Contemp Econ Pol 24(4):475–491

    Article  Google Scholar 

  • Gertler M, Karadi P (2011) A model of unconventional monetary policy. J Monet Econ 58:17–34

    Article  Google Scholar 

  • Guimares R, Karacadag C (2004) The empirics of foreign exchange intervention in emerging markets: the cases of Mexico and Turkey, IMF Working Paper 04/123 (Washington:International Monetary Fund)

  • Henderson D, Rogoff K (1982) Negative net foreign asset positions and stability in a world portfolio balance model. J Int Econ 13:85–104

    Article  Google Scholar 

  • IMF (2011a) Foreign exchange market intervention: how good a defense against appreciation winds? Regional economic outlook: western hemisphere, Chapter 3 (Washington: International Monetary Fund)

  • Kamil H (2008) Is central bank intervention effective under inflation targeting regimes? The case of Colombia, IMF Working Paper 08/88 (Washington: International Monetary Fund)

  • Krugman P (1979) A Model of Balance-of-Payments Crises. J Money Credit Bank 11 (3): 311–25

    Article  Google Scholar 

  • Kouri P (1976) Capital Flows and the Dynamics of the Exchange Rate, Seminar Paper 67 (Stockholm: Institute for International Economic Studies)

  • Kumhof M (2010) On the theory of sterilized foreign exchange intervention. J Econ Dyn Control 34(8):1403–1420

    Article  Google Scholar 

  • Leitemo K, Sderstrm Ulf (2005) Simple monetary policy rules and exchange rate uncertainty. J Int Money Finance 24:481–507

    Article  Google Scholar 

  • Monacelli T (2004) Into the Mussa Puzzle: Monetary Policy Regimes and the Real Exchange Rate in a Small Open Economy. J Int Econ 62:191–217

    Article  Google Scholar 

  • Morn E, Winkelried D (2005) Monetary Policy Rules for Financially Vulnerable Economies. J Dev Econ 76:25–51

    Google Scholar 

  • Natalucci F, Ravenna F (2002) The road to adopting the Euro: monetary policy and exchange rate regimes in EU candidate countries, international finance discussion papers 741. (Washington: Board of Governors of the Federal Reserve System)

  • Neely CJ (2011) A foreign exchange intervention in an Era of restraint. Fed Reserv Bank St Louis Rev 93(5):24–303

    Google Scholar 

  • Obstfeld M, Shambaugh J, Taylor A (2004) The trilemma in history: tradeoffs among exchange rates, monetary policies and capital mobility, NBER working paper 10396. Cambridge: National Burau of Economic Activity

  • Ostry J, Ghosh A, Chamon M (2012) Two targets, two instruments: monetary and exchange rate policies in emerging market economies, staff discussion notes No. 12/1, (Washington: International Monetary Fund)

  • Parrado E (2004a) Inflation targeting and exchange rate rules in an open economy, IMF Working Paper 04/21, Washington: International Monetary Fund

  • Parrado E (2004b) Singapore’s unique monetary policy: how does it work? IMF working paper 04/10. (Washington: International Monetary Fund)

  • Reserve Bank of Australia (2008) Statement on monetary policy November. (Canberra: Reserve Bank of Australia)

  • Rotemberg J (1982) Monopolistic price adjustment and aggregate output. Rev Econ Stud 49(4):517–531

    Article  Google Scholar 

  • Roger S, Restrepo J, Garcia C (2009) Hybrid inflation targeting regimes, IMF working paper 09/324. (Washington: International Monetary Fund)

  • Schmitt-Groh S, Uribe M (2003) Closing small economy models. J Int Econ 61:163–185

    Article  Google Scholar 

  • Swiss National Bank (2008) Quarterly Bulletin Fourth Quarter. (Zurich: Swiss National Bank)

  • Taylor J (2001) The role of the exchange rate in monetary policy rules. Am Econ Rev Pap Proc 91(2):263–267

    Article  Google Scholar 

  • Tuna G (2011) The effectiveness of central bank intervention: evidence from Turkey. Appl Econ 43 (14):1801–1815

    Article  Google Scholar 

  • Woodford M (2005) Comment on using a long-term interest rate as the monetary policy instrument. J Monet Econ 52:881–887

    Article  Google Scholar 

Download references

Acknowledgments

The authors would like to thank Olivier Blanchard, Jonathan Ostry, Alex Cukierman, seminar participants at the 2009 Central Bank Macroeconomic Workshop in Jerusalem and the 2010 IMF Workshop on Frameworks for Policy Analysis in Low–Income Countries, two anonymous referees, and the editor, for helpful comments and suggestions. Enrico Berkes provided excellent research assistance.

Author information

Authors and Affiliations

  1. IMF, Washington DC, USA

    Jaromir Benes, Andrew Berg & Rafael A. Portillo

  2. OGResearch, Sibeliova 41, Prague 6, 16200, Czech Republic

    David Vavra

Authors
  1. Jaromir Benes
    View author publications

    You can also search for this author in PubMed Google Scholar

  2. Andrew Berg
    View author publications

    You can also search for this author in PubMed Google Scholar

  3. Rafael A. Portillo
    View author publications

    You can also search for this author in PubMed Google Scholar

  4. David Vavra
    View author publications

    You can also search for this author in PubMed Google Scholar

Corresponding author

Correspondence to Rafael A. Portillo.

Additional information

This paper is part of a research project on macroeconomic policy in low-income countries supported by the U.K.s Department for International Development. The views expressed in this paper are those of the author(s) and do not necessarily represent those of the IMF, IMF policy or of DFID.

Appendix

Appendix

Second–order approximation to utility

Starting from the steady state (at period −1), taking a second order approximation to the discounted sum of utility flows yields the following relation:

$$U=E_{0}\left[\sum_{t=0}^{\infty} \beta^{t}U_{t}\right]\approx\overline{U}+\sum_{t=0}^{\infty}\beta^{t}E_{0}\left[\underbrace{\hat{c}_{t}-(1+\zeta)\hat{y}_{t}}_{A_{t}}\right]-\frac{1+\phi}{\gamma}\sum_{t=0}^{\infty}\beta^{t}E_{0}\left[\hat{y}_{t}^{2}\right]. $$

Note that \(\hat {c}_{t}-(1+\zeta )\hat {y}_{t}=(1-\omega _{n})\hat {c}_{m,t}-(1-\omega _{n}+\zeta )\hat {y}_{x,t}\). Forward iterations of the balance of payments imply:

$$\sum_{t=0}^{\infty}\beta^{t}E_{0}\left[A_{t}\right]=(1+\zeta)\sum_{t=0}^{\infty}\beta^{t}E_{0}\left[\hat{tot}_{t}-\overline{l}\beta\hat{i}^{*}_{t}\right]=t.i.p., $$

where t.i.p. denotes terms independent of policy. The above relation implies the discounted sum of utility, up to a second–order approximation, is proportional to the discounted sum of squared variations in output:

$$U-\overline{U}\approx-\frac{1+\phi}{\gamma}\sum_{t=0}^{\infty}\beta^{t}E_{0}\left[\hat{y}_{t}^{2}\right]+t.i.p. $$

Rights and permissions

Reprints and permissions

About this article

Check for updates. Verify currency and authenticity via CrossMark

Cite this article

Benes, J., Berg, A., Portillo, R.A. et al. Modeling Sterilized Interventions and Balance Sheet Effects of Monetary Policy in a New-Keynesian Framework. Open Econ Rev 26, 81–108 (2015). https://doi.org/10.1007/s11079-014-9320-1

Download citation

  • Published:

  • Issue Date:

  • DOI: https://doi.org/10.1007/s11079-014-9320-1

Keywords

JEL Classifications

Search

Navigation