Working Paper
Optimal Foreign Reserve Intervention and Financial Development
Abstract: We document evidence of a U-shaped relationship between financial development and the adjustments of foreign exchange (FX) reserve holdings in response to a U.S. interest rate increase. Countries with intermediate levels of financial development sell reserves aggressively, while those with low or high development adjust little. Domestic interest rate responses are not systematically related to financial development. A model with borrowing constraints and foreign-currency debt rationalizes these findings: the associated pecuniary externality is maximized at intermediate levels of financial development. Calibrated to match the observed leverage and currency composition, the model reproduces the empirical U-shaped relationship under optimal FX reserve policy, and this relation is robust under a range of conventional interest-rate policy regimes.
JEL Classification: F32; F38; E52;
https://doi.org/10.24149/wp2538
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Bibliographic Information
Provider: Federal Reserve Bank of Dallas
Part of Series: Working Papers
Publication Date: 2025-11-03
Number: 2538