Evaluating sterilized intervention under an inflation-targeting framework: the case of the Philippines

Josef T. Yap


After the 1997 financial crisis, several East Asian economies, including the Philippines, adopted an inflation-targeting framework. The shift in the policy stance of the Bangko Sentral ng Pilipinas (bsp) came with the acknowledgement that a flexible exchange rate framework is better suited to cushioning domestic economic performance from external disturbances than fixed nominal exchange rates. However, many inflation-targeting central banks, including the bsp, have continued to intervene in the foreign exchange market. This paper evaluates the impact of sterilized intervention using an economy-wide macroeconometric model instead of a partial-equilibrium framework. A loss function is used to evaluate the effectiveness of sterilized intervention, the latter being modeled as incorporating the exchange rate in the monetary authority’s reaction function. The key features of the New Keynesian macroeconometric model are as follows: (a) the policy interest rate of the BSP responds to inflationary, output gap, and exchange rate pressures; (b) changes in the BSP policy rate affect changes in the nominal exchange rate based on the uncovered interest parity (UIP) condition; and (c) the nominal peso-dollar rate is an effective transmission mechanism, as both direct and indirect pass-through effects to inflation are relatively above average. Theory indicates that incorporating the exchange rate in the BSP reaction function may lead to unintended consequences. Simulation results show that such a policy has a favorable outcome if the exchange rate also appears in the bsp’s objective function. Otherwise the exchange rate has to be dropped from the reaction function.

Classification-JEL: C32, E52


foreign exchange intervention; monetary policy rule; central bank objective function

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