Foreign exchange intervention and the Dutch disease under incomplete information

Abstract

This study examined the effectiveness of foreign exchange intervention as a policy response to the Dutch disease episode in an oil-exporting developing economy when the monetary authority is uncertain about the persistence of oil price shocks. Based on the results of the different scenarios modelled, the policy response to the Dutch disease will have to go beyond foreign exchange intervention to embrace structural reforms that will address the self-replicating causes of the continuous decline in manufacturing output. There is, however, still room to explore the optimal foreign exchange intervention (FXI) policy in response to the Dutch disease at least in the short run. The optimal FXI policy when the monetary authority has incomplete information on the persistence of an oil price shock; that is, whether it is a temporary or a permanent shock, would be a sustained accumulation of reserves (preferably beyond 5 quarters) to lean against appreciation pressures on the real exchange rate and prevent the decline of manufacturing output. Also, the results show that conventional monetary policy outperforms central bank intervention over the entire period adopted (from 1983Q1 to 2020Q4) but was outperformed by foreign exchange intervention when a sub-sample analysis was performed (for 1998Q1 to 2020Q4). This reflects the impact of the practice of Central Banks in developing economies that began accumulating reserves actively in the early 2000s. There is, however, a need for better coordination between both policy instruments in dealing with the Dutch disease episode.