Working Paper: CEPR ID: DP18469
Authors: Philippe Bacchetta; Kenza Benhima; Brendan Berthold
Abstract: We examine the welfare-based opportunity cost of foreign exchange (FX) intervention when both CIP and UIP deviations are present. We consider a small open economy that receives international capital flows through constrained international financial intermediaries. Deviations from CIP come from limited arbitrage or through a convenience yield, while UIP deviations are also affected by risk. We show that the sign of CIP and UIP deviations may differ for safe haven countries. We find that there may be a benefit, rather than a cost, of FX reserves if international intermediaries value the safe haven properties of a currency more than domestic households. We show that this has been the case for the Swiss franc and the Japanese Yen. We examine the optimal policy of a constrained central bank planner in this context.
Keywords: Foreign Exchange Intervention; CIP; UIP; Safe Haven Economies
JEL Codes: No JEL codes provided
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| CIP deviations (L15) | positive utility gain (D11) |
| FX reserves (F31) | benefit rather than cost (D61) |
| FX interventions (F31) | welfare implications (I30) |
| covariance of excess returns (C10) | utility cost of FX interventions (F31) |
| international intermediaries (F33) | value safe haven properties (D14) |
| central bank's interventions (E58) | beneficial under certain conditions (D61) |
| global risk increases (F65) | central bank's incentives (E58) |