Banco de la República's policy strategy seeks to maintain a low and stable inflation rate, as well as to achieve output levels close to the economy’s potential. The Bank's policy also contributes to preserve the stability of the financial and payment systems. Flexibility of the exchange rate is considered a fundamental element to achieve these objectives. First of all, in a flexible exchange rate regime, the exchange rate serves as an adjustment variable against economic shocks, reducing the volatility of economic activity. Second, exchange rate flexibility allows for the independent use of the interest rate as an instrument to bring inflation and output closer to their desired values. Third, flexibility of the exchange rate reduces the incentives for excessive exchange-rate risk-taking by economic agents, which is vital to maintain financial stability.
As the foreign exchange authority, however, Banco de la República can intervene in the foreign exchange market. Such intervention does not limit the exchange rate flexibility, nor does it intend to set or achieve any specific level of the exchange rate, and pursues objectives compatible with the inflation targeting strategy. Specifically, the Bank’s intervention seeks to: (i) increase the level of foreign reserves in order to reduce external vulnerability and improve the conditions of access to international financing; (ii) mitigate exchange-rate movements that do not clearly reflect the behavior of the fundamentals of the economy and that may negatively affect inflation and economic activity; and (iii) moderate rapid and sustained deviations in the exchange rate vis-à-vis its trend, in order to avoid disorderly behaviors in the financial markets.
To ensure the compatibility of the exchange-rate intervention with the inflation targeting strategy, sales and purchases in the foreign exchange market are sterilized as necessary in order to stabilize the short-term interest rate at the level that the Board of Directors deems consistent with the inflation target and with the evolution of output around its potential level. This means that the monetary expansion or contraction generated by foreign exchange sales or purchases is offset so that the short-term interest rate does not deviate from the level set by the Board of Directors.
The decision to intervene considers the benefits and costs for the country and its effect on the Central Bank's financial statements. The amounts for purchasing foreign currencies are determined so that the level of external liquidity of the Central Bank covers the external deficit, payments of the external debt, and other potential capital outflows.