Foreign Exchange Intervention and the Dutch Disease

Author/Editor:

Julia Faltermeier ; Ruy Lama ; Juan Pablo Medina

Publication Date:

March 27, 2017

Electronic Access:

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Disclaimer: IMF Working Papers describe research in progress by the author(s) and are published to elicit comments and to encourage debate. The views expressed in IMF Working Papers are those of the author(s) and do not necessarily represent the views of the IMF, its Executive Board, or IMF management.

Summary:

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.

Series:

Working Paper No. 17/70

Subject:

English

Publication Date:

March 27, 2017

ISBN/ISSN:

9781475589238/1018-5941

Stock No:

WPIEA2017070

Price:

$18.00 (Academic Rate:$18.00)

Format:

Paper

Pages:

36

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