Winners and losers of central bank foreign exchange interventions

Abstract

Interventions in foreign exchange markets are indispensable for most central banks and recent years have witnessed an increase in their frequency and magnitude. However, little is known about their implications on agents’ welfare. This paper investigates the topic by employing a small open economy DSGE model with savers and borrowers in both local and foreign currencies, where the central bank intervenes to smooth out exchange rate volatility by changing its foreign reserve. Interventions occur following the foreigners’ decision to sell (or buy) domestic assets, thus weakening (or strengthening) the local currency. The model allows the disentanglement of welfare implications by type of agent and source of exchange rate imbalance, which is novel in the literature, providing useful insight for central bankers. The findings highlight the benefits of interventions in the case of foreign financial shocks, especially when the level of currency mismatch in the economy is high. However, when exchange rate disequilibrium stems from domestic developments, the intervention generates winners and losers.