Foreign Exchange Intervention and the Dutch Disease

37 Pages Posted: 12 May 2017

See all articles by Julia Faltermeier

Julia Faltermeier

Universitat Pompeu Fabra

Ruy Lama

International Monetary Fund (IMF)

Juan Medina

Adolfo Ibanez University

Date Written: March 2017

Abstract

We study the optimal foreign exchange (FX) intervention policy in response to a positive terms of trade shock and associated Dutch disease episode in a small open economy model. We find that during a Dutch disease episode tradable production drops below the socially optimal level, resulting in lower welfare under learning by-doing (LBD) externalities. FX reserves accumulation improves welfare by preventing a large appreciation of the real exchange rate and by inducing an efficient reallocation between the tradable and non-tradable sectors. For an empirically plausible parametrization of LBD externalities, the model predicts that in response to a 10 percent increase in commodity prices FX reserves should increase by 1.5 percent of GDP. We also find that the welfare gains from optimally using FX reserves are twice as high as the gains from relying only on monetary policy. These results suggest that FX intervention is a beneficial policy to counteract the loss of competitiveness during a Dutch disease episode.

Keywords: Central banks and their policies, Foreign exchange, Dutch Disease; Learning-by-Doing Externalities; Foreign Exchange Intervention, Dutch Disease, Learning-by-Doing Externalities, Foreign Exchange Intervention, Open Economy Macroeconomics

JEL Classification: E58, F31, F41

Suggested Citation

Faltermeier, Julia and Lama, Ruy and Medina, Juan, Foreign Exchange Intervention and the Dutch Disease (March 2017). IMF Working Paper No. 17/70. Available at SSRN: https://ssrn.com/abstract=2967425

Julia Faltermeier (Contact Author)

Universitat Pompeu Fabra ( email )

Ramon Trias Fargas, 25-27
Barcelona, E-08005
Spain

Ruy Lama

International Monetary Fund (IMF) ( email )

700 19th Street, N.W.
Washington, DC 20431
United States

Juan Medina

Adolfo Ibanez University ( email )

Diagonal Las Torres 2640 Peñaleón
Presidente Errázuriz 3485 Las Condes
Santiago, 794-1169
Chile

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