Foreign Exchange Intervention with UIP and CIP Deviations
We examine the opportunity cost of foreign exchange (FX) intervention when both CIP and UIP deviations are present. We consider a small open economy that receives international capital flows through constrained international financial intermediaries. Deviations from CIP come from limited arbitrage or through a convenience yield, while UIP deviations are also affected by risk. We show that the sign of CIP and UIP deviations may differ for safe haven countries. We examine the optimal policy of a Ramsey central bank planner in this context. We determine the various factors influencing optimal policy decisions, with a focus on FX interventions. We find that there may be no opportunity cost of FX intervention in a safe haven country like Switzerland, even if it faces a negative CIP deviation.