Exchange Rate Effects of Financial Regulations

In this paper we analyze the effects of financial constraints on the exchange rate through the portfolio balance channel. We use a sharp policy discontinuity within the Colombian financial system to empirically test for the portfolio balance channel, using high frequency data during the period of 2004–2015. Our findings suggest that the effects on the exchange rate are short-lived and significant only when banking constraints are binding. To understand the mechanism behind this result we construct a tractable two-period general equilibrium model in which banking limits on foreign holdings inhibit capital flows. When these limits bind, departures from the uncovered interest rate parity enable sterilized foreign exchange interventions to influence the exchange rate. © 2019 Elsevier Ltd

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