On the theory of sterilized foreign exchange intervention

Abstract

Abstract Standard theory finds that, given uncovered interest parity, sterilized foreign exchange intervention should not affect equilibrium prices and quantities. This paper shows that when, as in the data, taxation is not sufficiently flexible in response to spending shocks, uncovered interest parity is replaced by a monotonically increasing relationship between the stock of domestic currency government debt and domestic interest rates. Sterilized intervention then becomes a second independent monetary policy instrument that affects portfolios, interest rates, exchange rates and consumption. It should be most effective in developing countries, where fiscal spending volatility is large and domestic currency government debt is small.