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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

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 Working Paper Series with number 2004-30.

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

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Keywords: Monetary policy ; Foreign exchange;

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References

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  1. Burnside, Craig & Eichenbaum, Martin & Rebelo, Sergio, 2001. "Hedging and financial fragility in fixed exchange rate regimes," European Economic Review, Elsevier, vol. 45(7), pages 1151-1193.
  2. 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.
  3. Alain Ize & Eric Parrado, 2002. "Dollarization, Monetary Policy, and the Pass-Through," IMF Working Papers 02/188, International Monetary Fund.
  4. V.V. Chari & Patrick J. Kehoe, 1989. "Sustainable plans," Staff Report 122, Federal Reserve Bank of Minneapolis.
  5. Ricardo Hausmann & Michael Gavin & Carmen Pagés-Serra & Ernesto H. Stein, 1999. "Financial Turmoil and Choice of Exchange Rate Regime," Research Department Publications 4170, Inter-American Development Bank, Research Department.
  6. Ricardo Hausmann & Michael Gavin & Carmen Pagés-Serra & Ernesto H. Stein, 1999. "Financial Turmoil and the Choice of Exchange Rate Regime," IDB Publications 4128, Inter-American Development Bank.
  7. Guillermo A. Calvo & Carmen M. Reinhart, 2000. "Fear of Floating," NBER Working Papers 7993, National Bureau of Economic Research, Inc.
  8. Ricardo Caballero & Arvind Krishnamurthy, 2005. "Exchange Rate Volatility and the Credit Channel in Emerging Markets: A Vertical Perspective," International Journal of Central Banking, International Journal of Central Banking, vol. 1(1), May.
  9. Eduardo Moron & Juan F. Castro, 2003. "Dedollarizing the Peruvian Economy," Macroeconomics 0312005, EconWPA.
  10. Martin Schneider & Aaron Tornell, 2004. "Balance Sheet Effects, Bailout Guarantees and Financial Crises," Review of Economic Studies, Wiley Blackwell, vol. 71, pages 883-913, 07.
  11. Philippe Aghion & Philippe Bacchetta & Abhijit Banerjee, 1999. "A Simple Model of Monetary Pollicy and Currency Crises," Working Papers 99.05, Swiss National Bank, Study Center Gerzensee.
  12. Stokey, Nancy L., 1991. "Credible public policy," Journal of Economic Dynamics and Control, Elsevier, vol. 15(4), pages 627-656, October.
  13. Olivier Jeanne, 2003. "Why Do Emerging Economies Borrow in Foreign Currency?," IMF Working Papers 03/177, International Monetary Fund.
  14. Giancarlo Corsetti & Paolo Pesenti, 2002. "Self-Validating Optimum Currency Areas," NBER Working Papers 8783, National Bureau of Economic Research, Inc.
  15. Paul Krugman, 1999. "Balance Sheets, the Transfer Problem, and Financial Crises," International Tax and Public Finance, Springer, vol. 6(4), pages 459-472, November.
  16. Ize, Alain & Yeyati, Eduardo Levy, 2003. "Financial dollarization," Journal of International Economics, Elsevier, vol. 59(2), pages 323-347, March.
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Cited by:
  1. Tille, Cédric, 2008. "Financial integration and the wealth effect of exchange rate fluctuations," Journal of International Economics, Elsevier, vol. 75(2), pages 283-294, July.
  2. Franz Hamann & Julián Pérez & Paulina Restrepo, 2005. "On the Macroeconomic Effects of Public Debt Substitution," ENSAYOS SOBRE POLÍTICA ECONÓMICA, BANCO DE LA REPÚBLICA - ESPE.
  3. 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.
  4. Norbert Fiess & Rashmi Shankar, 2005. "Regime-Switching in Exchange Rate Policy and Balance Sheet Effects," Working Papers 2005_16, Business School - Economics, University of Glasgow.
  5. Abdul Abiad & John C Bluedorn & Jaime Guajardo & Petia Topalova, 2012. "The Rising Resilience of Emerging Market and Developing Economies," IMF Working Papers 12/300, International Monetary Fund.
  6. Eduardo Levy Yeyati, 2006. "Exchange Rate Regimes in the 2000s: A Latin American Perspective," Business School Working Papers exchangerate, Universidad Torcuato Di Tella.
  7. Enrique L. Kawamura & Daniel Heymann, 2005. "On Liability Dollarization: A Simple Model with Domestic and Foreign Creditors," Working Papers 80, Universidad de San Andres, Departamento de Economia, revised Feb 2005.
  8. Pelin Berkmen & Eduardo A. Cavallo, 2007. "Exchange Rate Policy and Liability Dollarization," IMF Working Papers 07/33, International Monetary Fund.
  9. Eduardo Levy Yeyati & Alain Ize, 2005. "Financial De-Dollarization," IMF Working Papers 05/187, International Monetary Fund.

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