Foreign Exchange Intervention under Policy Uncertainty

IMF Working Papers, March 17, 2016

Source details

Study focus: use of foreign exchange (FX) intervention as an additional policy instrument in an environment with learning, where agents infer the central bank policy rules from its policy actions.
Key modeling distinction:
- Full information regime: agents know central bank objectives and reaction functions.
- Policy uncertainty regime: agents perceive that monetary policy may also have exchange rate stabilization goals and learn the policy from observed actions.

Under full information:
- A central bank focused on stabilizing output and inflation can achieve better outcomes by using FX intervention as an additional policy tool.
Under policy uncertainty:
- Use of FX intervention entails a trade-off: reducing output volatility while increasing inflation volatility.
Optimal magnitude of intervention:
- Having an additional policy tool is always beneficial.
- The optimal magnitude of intervention is higher in monetary policy regimes with lower uncertainty.
Interpretation:
- Benefits of using FX intervention as an additional stabilization tool are greater in regimes where monetary policy is credibly focused on output and inflation stabilization.

FX intervention can complement monetary policy to improve stabilization, but its net effect depends on the credibility and transparency of monetary policy.
In regimes with lower policy uncertainty (higher credibility), authorities can optimally employ larger FX intervention to improve outcomes.
In regimes with higher policy uncertainty, authorities face a trade-off and should weigh reductions in output volatility against potential increases in inflation volatility when designing intervention strategies.