Fear (No More) of Floating: Asset Purchases and Exchange Rate Dynamics

We provide a theory on currency dynamics, capital flows and conditions for central bank asset purchases to leave room for manoeuvre on conventional monetary policy. Asset purchases ease financial conditions and boost banks’ foreign borrowing capacity. The ensuing capital inflows lead to an exchange rate appreciation, which passes through to inflation and facilitates a policy rate easing. We find asset purchases curb the financial amplification of capital flow quantity shocks (but not price shocks) through this transmission mechanism. Our framework sheds light on stable currency dynamics observed after the unprecedented asset purchase announcements in emerging markets during the COVID-19 crisis.