Floating, Official Dollarization, and Macroeconomic Volatility:An Analysis for the Chilean Economy

This paper contrasts the volatility of the main macroeconomic variables of a small open economy in two environments: an official dollarization (OD) scheme and a flexible exchange regime (FER). A simple DSGE model calibrated for the Chilean economy is used as a laboratory to study the implications of these regimes on the standard deviations of key variables. Welfare implications are also analyzed for a central bank that it is concerned with output and inflation volatility. Our findings show that OD results in: higher real volatility due to the absence of ountercyclical monetary policy; lower inflation volatility because of a less volatile foreign interest rate; and, from a welfare perspective, OD is dominated by a FER when the central bank weighs considerably the deviations of inflation and output from the steady state. Also, OD implies higher fiscal deficit volatility as a consequence of higher tax revenue volatility, and a higher reaction to terms-of-trade shocks.