The portfolio balance channel of capital flows and foreign exchange intervention in a small open economy

Abstract

In this paper we extend a new Keynesian small open economy model with a segmented financial market featuring financial intermediaries as in Itskhoki and Mukhin (2021). The former ingredients generate deviations from the uncovered interest parity (UIP) condition. More precisely, the portfolio decisions of financial intermediaries add a time varying risk-premium element to the traditional UIP that depends on foreign exchange intervention (FXI) and FX orders by foreign investors. We present closed form solutions for optimal FXI. Additionally, we analyse the effectiveness of different FXI rules commonly discussed across policymakers. Our findings are as follows: (i) FXI rules can improve welfare in presence of the portfolio balance channel; (ii) under a general parametrization, fundamental shocks can trigger an inefficient path for the exchange rate; (iii) optimal policy calls for leaning against the wind to portfolio flow shocks and leaning with the wind to fundamental shocks; (iv) the effectiveness of FXI rules depends on the frequency and nature of the shocks and parameters characterizing the economy.