(DP 1987-03) A General Equilibruim Model of Exchange Market Intervention with Variable Sterilization

Abstract

This paper presents a general equilibrium model that incorporates three of the most prominent features of the recent floating exchange rate period: (1) rational asset markets; (2)"managed" exchange rates with partial (and variable) sterilization; and (3) the use by policymakers of both purely discretionary and systematic policies. The model is characterized by rational expectations, sticky prices, imperfect capital substitution, separate policy functions for domestic credit and reserves, and variable sterilization. The most important implications of the model are that (1) monetary, exchange rate, and variable sterilization policies may be used to pursue tradeoffs between internal and external objectives; and (2) these tradeoffs are nonlinear functions of the policies chosen (e.g., partial sterilization is not a simple linear interpolation of complete and zero sterilization).