Tolerance of Flexibility: Foreign Exchange Intervention and Managed Floating Redux

Abstract

In recent decades, there has been a rising share of countries with limited exchange rate flexibility (Ilzetzki et al., 2019), and foreign exchange (FX) intervention is commonly used among emerging market economies. Yet, the positive and normative implications of central banks' FX intervention and managed floating regime remain largely unexplored. Focusing on the case of China, we provide new empirical patterns of China's exchange rate policy after the global financial crisis. We find strong evidence that the central bank's FX intervention policy is nonlinear: it intervenes in heavily when the RMB exchange rate deviates from its long run trend by a large margin and otherwise it keeps inactive. Further, the central bank responds asymmetrically toward exchange rate depreciation and appreciation, with a higher tolerance for depreciation. To assess the policy effects of managed floating, we build a dynamic stochastic general equilibrium (DSGE) model embedded with an occasional binding constraint on the exchange rate. Compared to a fully floating exchange rate regime, FX intervention leads to a higher volatility in major variables on facing a foreign interest rate shock. Moreover, the exchange rate deviation constraint binds longer when the capital restriction is removed, which indicates that capital controls and FX policies are complements in terms of restricting exchange rate fluctuations.