Sterilization costs and exchange rate targeting

Abstract

This paper examines the movements of exchange rates and capital flows in an environment where an optimizing central bank pursuing the joint goals of inflation and output targeting engages in costly sterilization activities. Our results predict that when faced with increased sterilization costs, the central bank will choose to limit its sterilization activities allowing target variables, such as the nominal exchange rate, to adjust. ; We then test the predictions of a linearized version of the saddle-path solution to the model for a cross-country panel of developing countries. We use IV, GMM and simultaneous equation specifications to allow for the endogeneity of capital inflows. Our results confirm that a monetary policy does respond to sterilization costs.Foreign exchange ; Capital movements