Foreign exchange intervention for commodity booms and busts

Abstract

While the conventional policy prescription for dealing with commodity price shocks is the adoption of a flexible exchange rate regime, a view popularized by Friedman (1953), in practice many emerging economies decide to intervene in the foreign exchange market. In this paper, we evaluate the optimal exchange rate policy response to commodity price shocks in a small open economy model with learning-by-doing (LBD) externalities. We find that the optimal policy response to a commodity boom involves a large and sustained increase in the stock of foreign exchange reserves aimed at stabilizing the real exchange rate and tradable production. Moreover, the optimal policy resembles the actual dynamics of foreign exchange reserves observed in many emerging commodity-exporting economies during recent episodes of commodity booms. We also show that solely relying on monetary policy for dealing with commodity price shocks provides limited macroeconomic stabilization gains, as the policy rate is an ineffective instrument for addressing LBD externalities.