Monetary Policy in an Equilibrium Portfolio Balance Model,”International Monetary Fund and

This paper analyzes the general equilibrium effects of monetary policy choices on port-folio shares of domestic and foreign currency denominated securities. Concentrating on the small open economy case, it relates the optimal choice of portfolio shares to the domestic-foreign interest rate differential. The first contribution of the paper is to show that there are indeed conditions under which a portfolio balance relationship holds in equilibrium, after the effects of government tax and spending policies have been endogenized. This has two important implications. First, monetary policy can be shown to not only affect the level of inflation via a target path for the nominal anchor, but also the volatility (and also the level) of inflation via balance sheet operations. Most strikingly, sterilized intervention affects interest rates through its effect on inflation volatility. Second, this provides a theory of currency risk premia and their endogenous determination by fundamentals and monetary policy, including a determination of the conditions under which risk premia are or are not significant. We identify two factors that affect the effectiveness of sterilized intervention. The first is the prevalence of exogenous fiscal spending shocks, shocks that induce budget balancing exchange rate movements instead of being financed by endogenous tax responses. The sec-ond is the central bank’s initial balance sheet position- sterilized intervention has the largest effects if the government has only issued small amounts of domestic currency denominated debt. This suggests that the conditions that give rise to this type of imperfect asset substi-tutability are more likely to be observed in developing countries