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Monetary policy and the currency denomination of debt: a tale of two equilibria

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Roberto Chang
Andres Velasco

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Abstract

Exchange rate policies depend on portfolio choices, and portfolio choices depend on anticipated exchange rate policies. This opens the door to multiple equilibria in policy regimes. We construct a model in which agents optimally choose to denominate their assets and liabilities either in domestic or in foreign currency. The monetary authority optimally chooses to float or to fix the currency, after portfolios have been chosen. We identify conditions under which both fixing and floating are equilibrium policies: if agents expect fixing and arrange their portfolios accordingly, the monetary authority validates that expectation; the same happens if agents initially expect floating. We also show that a flexible exchange rate Pareto-dominates a fixed one. It follows that social welfare would rise if the monetary authority could precommit to floating.

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Paper provided by Federal Reserve Bank of San Francisco in its series Pacific Basin Working Paper Series with number 2004-30.

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Date of creation: 2004
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Handle: RePEc:fip:fedfpb:2004-30

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Keywords: Monetary policy ; Foreign exchange;

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  1. Martin Schneider & Aaron Tornell, 2000. "Balance SHeet Effects, Bailout Guarantees and Financial Crises," NBER Working Papers 8060, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
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  2. Stokey, Nancy L., 1991. "Credible public policy," Journal of Economic Dynamics and Control, Elsevier, vol. 15(4), pages 627-656, October. [Downloadable!] (restricted)
  3. Craig Burnside & Martin Eichenbaum & Sergio Rebelo, 1999. "Hedging and Financial Fragility in Fixed Exchange Rate Regimes," NBER Working Papers 7143, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
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  4. Hausmann, Ricardo & Panizza, Ugo & Stein, Ernesto, 2001. "Why do countries float the way they float?," Journal of Development Economics, Elsevier, vol. 66(2), pages 387-414, December. [Downloadable!] (restricted)
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  5. Giancarlo Corsetti & Paolo Pesenti, 2002. "Self-Validating Optimum Currency Areas," NBER Working Papers 8783, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
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  6. Paul Krugman, 1999. "Balance Sheets, the Transfer Problem, and Financial Crises," International Tax and Public Finance, Springer, vol. 6(4), pages 459-472, November. [Downloadable!] (restricted)
  7. Guillermo A. Calvo & Carmen M. Reinhart, 2002. "Fear Of Floating," The Quarterly Journal of Economics, MIT Press, vol. 117(2), pages 379-408, May. [Downloadable!] (restricted)
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  8. Eduardo Moron & Juan F. Castro, 2003. "Dedollarizing the Peruvian Economy," Macroeconomics 0312005, EconWPA. [Downloadable!]
  9. Aghion, Philippe & Bacchetta, Philippe & Banerjee, Abhijit, 2000. "A simple model of monetary policy and currency crises," European Economic Review, Elsevier, vol. 44(4-6), pages 728-738, May. [Downloadable!] (restricted)
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  10. Chari, V V & Kehoe, Patrick J, 1990. "Sustainable Plans," Journal of Political Economy, University of Chicago Press, vol. 98(4), pages 783-802, August. [Downloadable!] (restricted)
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  11. Eric Parrado & Alain Ize, 2002. "Dollarization, Monetary Policy, and the Pass-Through," IMF Working Papers 02/188, International Monetary Fund. [Downloadable!]
  12. Ize, Alain & Yeyati, Eduardo Levy, 2003. "Financial dollarization," Journal of International Economics, Elsevier, vol. 59(2), pages 323-347, March. [Downloadable!] (restricted)
  13. Jeanne, Olivier, 2003. "Why Do Emerging Economies Borrow in Foreign Currency?," CEPR Discussion Papers 4030, C.E.P.R. Discussion Papers. [Downloadable!] (restricted)
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  14. Ricardo Caballero & Arvind Krishnamurthy, 2004. "Exchange Rate Volatility and the Credit Channel in Emerging Markets: A Vertical Perspective," NBER Working Papers 10517, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
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  15. Ricardo Hausmann & Michael Gavin & Carmen Pagés-Serra & Ernesto H. Stein, 1999. "Financial Turmoil and Choice of Exchange Rate Regime," RES Working Papers 4170, Inter-American Development Bank, Research Department. [Downloadable!]
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  1. Pelin Berkmen & Eduardo E. Cavallo, 2007. "Exchange Rate Policy and Liability Dollarization: An Empirical Study," IMF Working Papers 07/33, International Monetary Fund. [Downloadable!]
  2. Fiess, Norbert & Shankar, Rashmi, 2005. "Regime-switching in exchange rate policy and balance sheet effects," Policy Research Working Paper Series 3653, The World Bank. [Downloadable!]
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  3. Eduardo Levy Yeyati, 2006. "Exchange Rate Regimes in the 2000s: A Latin American Perspective," Business School Working Papers exchangerate, Universidad Torcuato Di Tella. [Downloadable!]
  4. Cedric Tille, 2005. "Financial integration and the wealth effect of exchange rate fluctuations," Staff Reports 226, Federal Reserve Bank of New York. [Downloadable!]
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  5. Franz Hamann & Julián Pérez & Paulina Restrepo, . "Sobre los Efectos Macroeconómicos de la Composición de la Deuda Pública en Colombia," Borradores de Economia 332, Banco de la Republica de Colombia. [Downloadable!]
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