Foreign Exchange Reserves as a Tool for Capital Account Management

RePEc Short ID: pda415
ORCID iD: 0000-0002-8522-8826

Davis, J. Scott; Fujiwara, Ippei; Huang, Kevin X. D.; Wang, Jiao

doi:10.24149/gwp352

Working Paper

Foreign Exchange Reserves as a Tool for Capital Account Management

Abstract: Many recent theoretical papers have argued that countries can insulate themselves from volatile world capital flows by using a variable tax on foreign capital as an instrument of monetary policy. But at the same time many empirical papers have argued that only rarely do we observe these cyclical capital taxes used in practice. In this paper we construct a small open economy model where the central bank can engage in sterilized foreign exchange intervention. When private agents can freely buy and sell foreign bonds, sterilized foreign exchange intervention has no effect. But we analytically prove that when private agents cannot freely buy and sell foreign bonds, that is, under acyclical capital controls, optimal sterilized foreign exchange intervention is equivalent to an optimally chosen tax on foreign capital. Numerical simulations of the model show that a variable capital tax is a reasonable approximation for sterilized foreign exchange intervention under the levels of capital controls observed in many emerging markets.

Keywords: Central bank; small open economy; foreign exchange reserves; capital controls;

JEL Classification: E30; E50; F40;

https://doi.org/10.24149/gwp352