Foreign Exchange Intervention and the Dutch Disease

IMF Working Papers, March 27, 2017

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Foreign Exchange Intervention and the Dutch Disease

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Bibliographic details

• Authors: Julia Faltermeier, Ruy Lama, Juan Pablo Medina
• Published: March 27, 2017
• Series: IMF Working Papers
• DOI: https://doi.org/10.5089/9781475589238.001

Research question and model

• Studies 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.
• Incorporates learning-by-doing (LBD) externalities to assess social optimality of production allocations.

Key findings

• 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
  • 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.
• The welfare gains from optimally using FX reserves are twice as high as the gains from relying only on monetary policy.

Policy implications

• FX intervention is a beneficial policy to counteract the loss of competitiveness during a Dutch disease episode.
• Optimal FX reserves accumulation can be more effective than monetary policy alone in preserving tradable-sector activity and overall welfare.

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