Foreign Exchange Intervention And The Dutch Disease

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 learningby- 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.

This paper evaluates how successful is a policy of exchange rate stabilization to counteract the negative effects of a Dutch Disease episode. We consider a small open economy model that incorporates nominal rigidities and a learning-by-doing externality in the tradable sector. The paper shows that leaning against an appreciated exchange rate can prevent an inefficient loss of tradable output but at the cost of generating a misallocation of resources in other sectors of the economy. The paper also finds that welfare is a decreasing function of exchange rate intervention. These results suggest that stabilizing the nominal exchange rate in response to a Dutch Disease episode is highly distortionary.

We review the literature on Dutch disease, and document that shocks that trigger foreign exchange inflows (such as natural resource booms, surges in foreign aid, remittances, or capital inflows) appreciate the real exchange rate, generate factor reallocation, and reduce manufacturing output and net exports. We also observe that real exchange rate misalignment due to overvaluation and higher volatility of the real exchange rate lower growth. Regarding the effect of undervaluation of the exchange rate on economic growth, the evidence is mixed and inconclusive. However, there is no evidence in the literature that Dutch disease reduces overall economic growth. Policy responses should aim at adequately managing the boom and the risks associated with it.

This paper evaluates how successful is a policy of exchange rate stabilization to counteract the negative effects of a Dutch Disease episode. We consider a small open economy model that incorporates nominal rigidities and a learning-by-doing externality in the tradable sector. The paper shows that leaning against an appreciated exchange rate can prevent an inefficient loss of tradable output but at the cost of generating a misallocation of resources in other sectors of the economy. The paper also finds that welfare is a decreasing function of exchange rate intervention. These results suggest that stabilizing the nominal exchange rate in response to a Dutch Disease episode is highly distortionary.

This paper evaluates how successful is a policy of exchange rate stabilization to counteract the negative effects of a Dutch Disease episode. We consider a small open economy model that incorporates nominal rigidities and a learning-by-doing externality in the tradable sector. The paper shows that leaning against an appreciated exchange rate can prevent an inefficient loss of tradable output but at the cost of generating a misallocation of resources in other sectors of the economy. The paper also finds that welfare is a decreasing function of exchange rate intervention. These results suggest that stabilizing the nominal exchange rate in response to a Dutch Disease episode is highly distortionary.

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 learningby- 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.

This book explains why central banks continue to carry out foreign exchange interventions despite their poor track record. It uses confidential daily intervention data from the Bundesbank and the Federal Reserve.