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Foreign Exchange Intervention, Capital Flows, and Liability Dollarization

Author

Listed:
  • Castillo, Paul

    (Banco Central de Reserva del Perú)

  • Medina, Juan Pablo

    (Universidad Adolfo Ibáñez, Chile)

Abstract

This paper investigates the importance of foreign exchange intervention in dealing with shocks to global capital flows in emerging economies. We show in a VAR analysis that a shock to global capital flows has a sizable effect on economic activity, and this effect is amplified in emerging economies with liability dollarization. However, countries that systematically rely on sterilized foreign exchange intervention in response to movements in global capital flows, display lower output and real exchange rate volatility. Motivated by the empirical evidence, we develop a small open economy model with liability dollarization and balance sheets effects calibrated to an emerging economy. Our quantitative results show that liability dollarization amplifies the effects of fluctuations in capital flows and that foreign exchange intervention can reduce macroeconomic volatility and improve welfare. These results point to the importance of foreign exchange reserves in insulating emerging economies from the global financial cycle.

Suggested Citation

  • Castillo, Paul & Medina, Juan Pablo, 2021. "Foreign Exchange Intervention, Capital Flows, and Liability Dollarization," Working Papers 2021-006, Banco Central de Reserva del Perú.
    • Handle: RePEc:rbp:wpaper:2021-006
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    Cited by:

    1. Santiago Camara, 2021. "Spillovers of US Interest Rates: Monetary Policy & Information Effects," Papers 2111.08631, arXiv.org, revised Feb 2023.
    2. Elizabeth Bucacos & Javier García-Cicco & Miguel Mello, 2023. "Foreign Exchange Interventions and Foreign Shocks. The case of Uruguay," Documentos de trabajo 2023008, Banco Central del Uruguay.
    3. Ortiz, Marco & Herrera, Gerardo & Perez, Fernando, 2022. "The shine beneath: foreign exchange intervention in resource-rich economies," MPRA Paper 116208, University Library of Munich, Germany.
    4. Rodríguez, Gabriel & Castillo B., Paul & Hasegawa, Harumi, 2023. "Does the Central Bank of Peru respond to exchange rate movements? A Bayesian estimation of a New Keynesian DSGE model with FX interventions," The North American Journal of Economics and Finance, Elsevier, vol. 68(C).
    5. Santiago Camara, 2021. "US Spillovers of US Monetary Policy: Information effects & Financial Flows," Papers 2108.01026, arXiv.org, revised May 2024.

    More about this item

    Keywords

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    JEL classification:

    • E58 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Central Banks and Their Policies
    • F31 - International Economics - - International Finance - - - Foreign Exchange
    • F41 - International Economics - - Macroeconomic Aspects of International Trade and Finance - - - Open Economy Macroeconomics

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