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Currency boards, dollarized liabilities, and monetary policy credibility

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  • Diego Valderrama
  • Mark M. Spiegel

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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Bibliographic Info

Paper provided by Federal Reserve Bank of San Francisco in its series Working Paper Series 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:fedfwp:2003-07

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Keywords: Currency boards ; Dollarization ; Foreign exchange rates ; Monetary policy;

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References

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  1. Allan Drazen & Paul R. Masson, 1993. "Credibility of Policies versus Credibility of Policymakers," NBER Working Papers 4448, National Bureau of Economic Research, Inc.
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  16. Luis Felipe Céspedes & Roberto Chang & Andrés Velasco, 2002. "Dollarization of Liabilities, Net Worth Effects, and Optimal Monetary Policy," NBER Chapters, in: Preventing Currency Crises in Emerging Markets, pages 559-600 National Bureau of Economic Research, Inc.
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Cited by:
  1. Dominique Torre & Alain Raybaut, 2004. "Unions monétaires, caisses d'émission et dollarisation : les fondements analytiques des systèmes de change « ultra-fixes »," Revue d'Économie Financière, Programme National Persée, vol. 75(2), pages 37-54.

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