DP 2024/6 - Rong Li, Dongzhou Mei, Bing Tong: Gradual Portfolio Adjustment, Foreign Exchange Intervention, and Open Market Operations

Rong Li, Dongzhou Mei, Bing Tong

CFDS Discussion Paper 2024/6

Abstract

We introduce gradual adjustment costs for both domestic and foreign bonds in a New Keynesian small open economy model, unifying the theories of foreign exchange intervention and the liquidity effect. With gradual adjustment for foreign bonds, interest rate differentials lead to persistent capital flows. With adjustment costs for domestic bonds, open market operations generate a stronger liquidity effect, which has real effects in an environment with costly intermediation. Furthermore, under gradual portfolio adjustment, nominal interest rates change temporarily in response to asset transactions, so that the model can restore equilibrium when the steady-state asset ratios have changed.

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