The Portfolio Channel of Capital Flows and Foreign Exchange Intervention in A Small Open Economy
Marco Ortiz

Abstract:

In this paper we extend a new Keynesian small open economy model to include risk-averse FX dealers and FX intervention by the monetary authority. The former ingredients generate deviations from the uncovered interest parity (UIP) condition. More precisely, in this setup portfolio decisions of the dealers add endogenously a time variant risk-premium element to the traditional UIP that depends on FX intervention by the central bank and FX orders by foreign investors. We derive the optimal FX intervention policy and show that welfare can be approximated by the Backus-Smith wedge. Our findings are as follows: (i) FX intervention is a useful tool to improve welfare when international financial markets are segmented; (ii) FX intervention can affect the risk-bearing capacity of FX intermediaries, via a reduction of FX volatility; (iii) simple FX intervention rules' effectiveness, conditional on a monetary policy, depend on the frequency of shocks hitting the economy; and (iv) the interaction between the portfolio channel and current account dynamics eliminates unit root dynamics and can be used as a 'closing device' for a small open economy model. We present two additional extensions to this setup: (1) a banking sector with a costly-state-verification friction in loans and exogenous dollarization to capture 'balance sheet' effects and, (2) a banking sector with liquidity frictions, in which UIP deviations are a function of both liquidity and portfolio considerations.

Speaker:

Marco Ortiz, Profesor del Departamento Académico de Economía de la Universidad del Pacífico. Es Ph.D. en Economía y Magister en Investigación en Economía por la London School of Economics and Political Science (Inglaterra), y bachiller en Economía por la Universidad del Pacífico. Cuenta con experiencia docente en la Escuela de Postgrado de la Universidad del Pacífico en la Maestría en Economía y se desempeñó como Subgerente de Diseño de Política Monetaria y Jefe del Departamento de Modelos Macroeconómicos en el Banco Central de Reserva del Perú. Asimismo, fue Consultor y Asociado Profesional en el Banco Mundial. Áreas de especialización: Teoría macroeconómica, política monetaria y cambiaria, política macroprudencial, mercados financieros y métodos numéricos.