Foreign Exchange Interventions, Capital Controls and Monetary Policy : The Case of China

China has maintained a closed capital account to the private sector and channeled capital flows through the public sector by foreign exchange interventions. This paper presents an open economy model that incorporates this capital account policy configuration in order to study whether foreign exchange interventions can improve welfare in the presence of capital controls, compared to an open capital account. Furthermore, I analyze how these interventions affect the optimal conduct of monetary policy. I show that foreign exchange interventions improve welfare by strategically managing the terms-of-trade. In the presence of domestic nominal rigidity, interventions increase welfare even if monetary policy is set optimally. I find optimal monetary policy stabilizes inflation, while foreign exchange interventions correct terms-of-trade externalities