Foreign exchange reserves as a tool for capital account management

Recent theoretical papers argue that countries can insulate themselves from volatile world capital flows by using a variable tax on foreign capital as an instrument of monetary policy. But empirical papers argue that we rarely observe these cyclical capital flow taxes used in practice. We construct a small open economy model where the central bank engages in sterilized foreign exchange intervention. When private agents freely trade foreign bonds, sterilized intervention has no effect. But we prove that when frictions prevent the free trade in foreign bonds, optimal sterilized foreign exchange intervention is equivalent to an optimal tax on foreign capital. The model is then calibrated to match the levels of capital account restrictions that we observe in the data. For levels of capital account openness that we observe in many emerging market economies, a variable tax on capital flows is a close approximation for sterilized foreign exchange intervention.