Fear (no more) of floating: Asset purchases and exchange rate dynamics

Abstract

We provide a theory on currency dynamics, capital flows and conditions for emerging-market economy central bank asset purchases to leave room for maneuver for conventional monetary policy. Local-currency asset purchases ease financial conditions and boost banks' foreign borrowing capacity. Therefore, they curb the financial amplification of government bond sell-off shocks by mitigating private sector capital outflows and the accompanying exchange rate depreciation. The resulting limited rise in inflation reduces the pro-cyclicality of conventional monetary policy. Our framework sheds light on stable exchange rate dynamics observed after the unprecedented asset purchase announcements in emerging-market economies during the COVID-19 crisis.