Foreign exchange interventions and foreign shocks

We study the effects of exchange-rate interventions on relevant macroeconomic variables such as the exchange rate, inflation, activity, and interest rates. Instead of attempting to identify exogenous variations in the intervention policy (a frequent strategy in the related literature that raises many endogeneity concerns), we investigate the effect of interventions in dampening the impact of external shocks that are relevant determinants of exchange rate movements. To this end, we propose a novel approach, constrained impulse response functions, which allows the construction of counterfactual scenarios that are locally valid (i.e. marginal effects around average responses). We focus on the case of Uruguay, for which we exploit detailed data on the Central Bank’s operations in the exchange-rate market, leading to a clean measure of interventions that is not contaminated by other factors affecting the foreign reserves position (like valuation effects, a common problem in related studies). We find that interventions can help dampen exchange rate effects, although with a delay, and may have a non-trivial impact on inflation as well, but generally the macroeconomic consequences seems limited. Crucially, these effects depend on the type and sign of the external shock being considered.