Evidence suggests that developing countries are much more concerned with stabilizing the nominal exchange rate than developed countries. This paper presents a model to explain this observation, based on the hypotheses that both interventions and depreciations are costly. Interventions are costly because they generate a financial need in a fiscally constrained government that relies solely on distortionary taxes. Depreciations are costly because the country, in particular its financial sector, is exposed to a currency mismatch between its assets and its liabilities that is not effectively hedged. The results suggest that the amount of intervention will depend on the degree of currency mismatch between assets and liabilities, the elasticity of money demand, and the relative size of the financial system. It would be expected that countries with a high degree of currency mismatch and large financial sectors would intervene heavily in foreign exchange markets, as long as the money demand is not too sensitive to the nominal interest rate.
JEL classification: E5, F3, F41
Keywords: exchange rates, floating, currency mismatch, fiscal constraint, optimal policy
The author is indebted to Carlos Vegh for many discussions and his helpful suggestions. He would also like to thank Hal Cole, Arnold Harberger, Amartya Lahiri, Monika Piazzesi, Martin Schneider, Aaron Tornell, and seminar participants at UCLA, CEMA, FRB of Kansas City, and FRB Atlanta for their helpful comments. The views expressed here are the author’s and not necessarily those of the Federal Reserve Bank of Atlanta or the Federal Reserve System. Any remaining errors are the author’s responsibility.
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