FX policy when financial markets are imperfect

In the last 15 years, central banks have purchased securities at unprecedented levels via quantitative easing and foreign exchange intervention. These policies have constituted the core response to crises such as the 2008–09 Great Financial Crisis, the 2011–12 European sovereign debt crisis and the ongoing Covid-19 pandemic. In many cases, policymakers have resorted to these policies as traditional monetary policy was constrained by the zero lower bound. In this paper, I review recent advances in open economy analysis with financial frictions. This type of analysis offers a different take on exchange rates compared with their traditional role as shock absorbers. When international financial intermediation is imperfect, the exchange rate is pinned down by imbalances in the demand and supply of assets in different currencies and, crucially, by the limited risk-bearing capacity of the financial intermediaries that absorb these imbalances. Exchange rates are distorted by financial forces and can be a source of shocks to the real economy rather than a re-equilibrating mechanism.