Foreign Exchange Interventions and Foreign Shocks. The case of Uruguay

We study the effects of exchange rate interventions in Uruguay 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. This estimation is carried out through a novel econometric tool called constrained impulse response functions, which allows to construct counterfactual scenarios that are locally valid (i.e. marginal effects around average responses). Moreover, we exploit a detailed data on Central Bank’s operations in the exchange-rate market, leading to a clean measure of interventions that is not contaminated from other factors affecting the foreign reserves position (thus improving over most related studies). We find that interventions can help dampen exchange rate effects, and may have non-trivial effects on inflation as well, but generally the consequences in terms of activity are limited. Crucially, these effects depend on the type and sign of the external shock under consideration.