Optimal Exchange Rate Policy with Oil Shocks

IMF Working Papers, February 20, 2026

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Study of optimal monetary and exchange rate policy in a small open economy facing oil price shocks.
Model features segmented financial markets that generate endogenous UIP deviations.
First-best allocation is achieved through a combination of interest rate policy and foreign exchange intervention (FXI).
Monetary policy role: stabilize domestic inflation and the output gap.
FXI role: target the UIP wedge to offset financial frictions.
Key mechanism: oil price shocks endogenously move the net foreign asset position, creating financial imbalances that make FXI essential — distinct from the exogenous financial shocks emphasized in the literature.
FXI breaks the destabilizing link between real commodity shocks and financial risk premia.

Calibration: a calibrated oil exporter is used for quantitative evaluation.
Welfare losses under suboptimal regimes:
- Suboptimal regimes such as a free float or a simple peg entail sizable welfare losses of around 2% in consumption-equivalent terms.
- Peg, and especially peg with fuel subsidies, can outperform free floats in the calibrated setting.

Optimal policy package:
- Use interest rate policy to stabilize domestic inflation and the output gap.
- Use FXI to target and offset endogenous UIP wedges generated by segmented financial markets.
Policy implication: FXI is crucial when real commodity (oil) shocks transmit to financial risk premia via changes in net foreign asset positions.
Comparison of regimes:
- Free float: associated with sizable welfare loss (around 2% consumption-equivalent).
- Simple peg: also entails sizable welfare loss, but can outperform free float in some cases.
- Peg with fuel subsidies: can perform especially well relative to free float in the calibrated oil exporter.