Currency boards, dollarized liabilities, and monetary policy credibility

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Currency boards, dollarized liabilities, and monetary policy credibility

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Diego Valderrama
Mark M. Spiegel

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Abstract

The recent collapse of the Argentine currency board raises new questions about the desirability of formal fixed exchange rate regimes in modern developing economies. This paper examines the impact of dollarized liabilities with potential default for a currency board with costly abandonment. We compare the performance of a currency board to a central bank with full discretion in two environments: One with only idiosyncratic firm shocks, and one with both idiosyncratic shocks and shocks to the dollar-euro rate. We show that the possibility of default with peso-valued exports generates a risk premium on borrowing tied to expected future monetary policy. In addition, the presence of dollarized liabilities mitigates the time-inconsistency problem faced by the monetary authority. Finally, our numerical results demonstrate that the relative performance of the central bank under discretion compared to a currency board is ambiguous with only firm shocks, but that discretion unambiguously dominates when we also introduce shocks to the dollar-euro rate.

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Paper provided by Federal Reserve Bank of San Francisco in its series Working Papers in Applied Economic Theory with number 2003-07.

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Date of creation: 2003
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Publication status: Published in Journal of International Money and Finance, Vol. 22, 1065-1087, (December 2003)
Handle: RePEc:fip:fedfap:2003-07

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Article
- Spiegel, Mark M. & Valderrama, Diego, 2003. "Currency boards, dollarized liabilities, and monetary policy credibility," Journal of International Money and Finance, Elsevier, vol. 22(7), pages 1065-1087, December. [Downloadable!] (restricted)

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