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Optimal Foreign Reserve Intervention and Financial Development

Author

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  • J. Scott Davis
  • Kevin X. D. Huang
  • Zheng Liu
  • Mark M. Spiegel

Abstract

We document evidence of a U-shaped relationship between financial development and the adjustments of foreign exchange (FX) reserve holdings in response to a U.S. interest rate increase. Countries with intermediate levels of financial development sell reserves aggressively, while those with low or high development adjust little. Domestic interest rate responses are not systematically related to financial development. A model with borrowing constraints and foreign-currency debt rationalizes these findings: the associated pecuniary externality is maximized at intermediate levels of financial development. Calibrated to match the observed leverage and currency composition, the model reproduces the empirical U-shaped relationship under optimal FX reserve policy, and this relation is robust under a range of conventional interest-rate policy regimes.

Suggested Citation

  • J. Scott Davis & Kevin X. D. Huang & Zheng Liu & Mark M. Spiegel, 2025. "Optimal Foreign Reserve Intervention and Financial Development," Working Papers 2538, Federal Reserve Bank of Dallas.
    • Handle: RePEc:fip:feddwp:102072
    DOI: 10.24149/wp2538
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    References listed on IDEAS

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    1. Robert Driskill & Stephen McCafferty, 1980. "Exchange-Rate Variability, Real and Monetary Shocks, and the Degree of Capital Mobility Under Rational Expectations," The Quarterly Journal of Economics, President and Fellows of Harvard College, vol. 95(3), pages 577-586.
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    JEL classification:

    • F32 - International Economics - - International Finance - - - Current Account Adjustment; Short-term Capital Movements
    • F38 - International Economics - - International Finance - - - International Financial Policy: Financial Transactions Tax; Capital Controls
    • E52 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Monetary Policy

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