Foreign exchange intervention and financial stability

The effects of sterilized intervention are studied in a model with financial frictions. The central bank operates a managed float and issues sterilization bonds. In contrast with most of the existing literature, these bonds are held only by banks, and are imperfect substitutes to loans. The model is parameterized and used to study optimal policy responses to capital inflows associated with a transitory shock to world interest rates. The results show that sterilized intervention can be expansionary due to a bank portfolio channel and may exacerbate risks to financial stability. Full sterilization is optimal only when that channel is absent. The optimal degree of intervention is more aggressive when the central bank can choose simultaneously the degree of sterilization; in that sense, and conditional on intervention taking place, the instruments are complements. When the central bank's objective function also accounts for the implicit cost of sterilization, and concerns with that cost are sufficiently high, intervention and sterilization can be substitutes–independently of whether exchange rate and financial stability considerations also matter for policymakers.