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Federal Reserve Bank of New York
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News shocks, monetary policy, and foreign currency positions
Bianca De Paoli
Hande Küçük

Over the past two decades, before the global financial crisis, there was a rapid rise in the size of gross external portfolio positions as well as a decrease in the net negative foreign currency exposure in external balance sheets. In this paper, we present a theoretical model in which these portfolio facts can be explained by changes in monetary policy rules and the composition of shocks that underlie economic fluctuations. We find that policies with a strong emphasis on price stability would imply shorter positions in foreign currency when the dominant sources of fluctuations are supply shocks. The model suggests that longer and larger foreign currency positions, as observed in the data, would be consistent with a world in which central banks are more committed to price stability, and that changes in economic conditions come mainly from demand shocks. Moreover, in this case, a move toward flexible exchange rate regimes would also imply larger equilibrium portfolios and these would be tilted toward foreign assets.

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Bianca De Paoli & Hande Küçük, News shocks, monetary policy, and foreign currency positions, Federal Reserve Bank of New York, Staff Reports 750, 01 Dec 2015.
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Keywords: portfolio choice; international transmission of shocks; monetary policy
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