We document evidence of a U-shaped relationship between financial development and the adjustments of foreign exchange (FX) reserve holdings in response to a U.S. interest rate increase. Countries with intermediate levels of financial development sell reserves aggressively, while those with low or high development adjust little. Domestic interest rate responses are not systematically related to financial development. A model with borrowing constraints and foreign-currency debt rationalizes these findings: the associated pecuniary externality is maximized at intermediate levels of financial development. Calibrated to match the observed leverage and currency composition, the model reproduces the empirical U-shaped relationship under optimal FX reserve policy, and this relation is robust under a range of conventional interest-rate policy regimes.
Suggested citation:
Davis, J. Scott, Kevin X.D. Huang, Zheng Liu, and Mark M. Spiegel. 2025. “Optimal Foreign Reserve Intervention and Financial Development.” Federal Reserve Bank of San Francisco Working Paper 2025-27. https://doi.org/10.24148/wp2025-27