Abstract

Emerging market (EM) central banks are known to intervene in the foreign exchange rate market during times of financial risk and currency devaluation. This paper develops an open- economy New Keynesian DSGE model with imperfect financial markets and dollar-denominated debt in EM banking sector to test the effectiveness of sterilized foreign exchange intervention policy. The model finds that such intervention reduces EM long-run inflation, output gap and real exchange rate volatility as well as reducing EM welfare losses. The theoretical results of the model can rationalize the incentives as to why several EMs have turned to such intervention during the U.S. monetary tightening periods as well as in other periods of heightened financial risk in EMs.