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Sudden Stops and Optimal Foreign Exchange Intervention

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  • J. Scott Davis
  • Michael B. Devereux
  • Changhua Yu
Abstract
We model sudden stops in a small open economy as rare discrete events precipitated by increases in the world risk-free rate. When external debt is large, the model exhibits multiple equilibria, one where external debt and consumption remain high, and one with a collapse in external debt and consumption. Private agents delever following an increase in the world interest rate, but they fail to internalize the impact of deleveraging on the price of collateral. For high levels of debt, even a small increase in the world interest rate can eliminate the high debt equilibrium and the economy experiences a sudden stop. The central bank can use foreign exchange intervention to prevent the sudden stop. If reserves cannot be borrowed, optimal policy is to “lean against the wind”, buying foreign reserves ex-ante when private borrowing is high and selling them after an interest rate shock when private agents are deleveraging.

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  • J. Scott Davis & Michael B. Devereux & Changhua Yu, 2020. "Sudden Stops and Optimal Foreign Exchange Intervention," NBER Working Papers 28079, National Bureau of Economic Research, Inc.
    • Handle: RePEc:nbr:nberwo:28079
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    Cited by:

    1. Javier Bianchi & Guido Lorenzoni, 2021. "The Prudential Use of Capital Controls and Foreign Currency Reserves," NBER Working Papers 29476, National Bureau of Economic Research, Inc.
    2. Corsetti, G. & Maeng, S. H., 2023. "The Theory of Reserve Accumulation, Revisited," Cambridge Working Papers in Economics 2370, Faculty of Economics, University of Cambridge.
    3. Cecchetti, Stephen G. & Narita, Machiko & Rawat, Umang & Sahay, Ratna, 2023. "Addressing Spillovers from Prolonged U.S. Monetary Policy Easing," Journal of Financial Stability, Elsevier, vol. 64(C).
    4. Yun Jung Kim & Jing Zhang, 2023. "International Capital Flows: Private Versus Public Flows In Developing And Developed Countries," International Economic Review, Department of Economics, University of Pennsylvania and Osaka University Institute of Social and Economic Research Association, vol. 64(1), pages 225-260, February.
    5. George Pantelopoulos, 2024. "Can external sustainability be decoupled from the NIIP?," International Economics and Economic Policy, Springer, vol. 21(1), pages 89-116, February.
    6. Bengui, Julien & Bianchi, Javier, 2022. "Macroprudential policy with leakages," Journal of International Economics, Elsevier, vol. 139(C).
    7. Matteo Maggiori, 2021. "FX policy when financial markets are imperfect," BIS Working Papers 942, Bank for International Settlements.
    8. Samano, Agustin, 2022. "International reserves and central bank independence," Journal of International Economics, Elsevier, vol. 139(C).
    9. Maggiori, Matteo, 2021. "International Macroeconomics With Imperfect Financial Markets," SocArXiv z8g6r, Center for Open Science.
    10. Davis, J. Scott & Zlate, Andrei, 2023. "The global financial cycle and capital flows during the COVID-19 pandemic," European Economic Review, Elsevier, vol. 156(C).
    11. Corsetti, G. & Maeng, S. H., 2023. "The Theory of Reserve Accumulation, Revisited," Janeway Institute Working Papers 2319, Faculty of Economics, University of Cambridge.
    12. Giancarlo Corsetti & Seung Hyun Maeng, 2023. "The Theory of Reserve Accumulation, Revisited," RSCAS Working Papers 2013_53, European University Institute.

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    JEL classification:

    • E30 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles - - - General (includes Measurement and Data)
    • E50 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - General
    • F40 - International Economics - - Macroeconomic Aspects of International Trade and Finance - - - General

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