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Monetary Policy and the Currency Denomination of Debt: A Tale of Two Equilibria

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  • Andres Velasco
  • Roberto Chang

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 National Bureau of Economic Research, Inc in its series NBER Working Papers with number 10827.

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Date of creation: Oct 2004
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Publication status: published as Velasco, Andrés and Roberto Chang. “Monetary Policy and the Currency Denomination of Debt: A Tale of Two Equilibria.” Journal of International Economics 69 (2006): 150-175.
Handle: RePEc:nbr:nberwo:10827

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  1. Reinhart, Carmen & Calvo, Guillermo, 2002. "Fear of floating," MPRA Paper 14000, University Library of Munich, Germany.
  2. 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.
  3. 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.
  4. Olivier Jeanne, 2003. "Why Do Emerging Economies Borrow in Foreign Currency?," IMF Working Papers 03/177, International Monetary Fund.
  5. Paul Krugman, 1999. "Balance Sheets, the Transfer Problem, and Financial Crises," International Tax and Public Finance, Springer, vol. 6(4), pages 459-472, November.
  6. Chari, V V & Kehoe, Patrick J, 1990. "Sustainable Plans," Journal of Political Economy, University of Chicago Press, vol. 98(4), pages 783-802, August.
  7. Ricardo Hausmann & Ugo Panizza & Ernesto H. Stein, 2000. "Why Do Countries Float the Way They Float?," Research Department Publications 4205, Inter-American Development Bank, Research Department.
  8. 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.
  9. Giancarlo Corsetti & Paolo Pesenti, 2002. "Self-Validating Optimum Currency Areas," NBER Working Papers 8783, National Bureau of Economic Research, Inc.
  10. Eduardo Moron & Juan F. Castro, 2003. "Dedollarizing the Peruvian Economy," Macroeconomics 0312005, EconWPA.
  11. Alain Ize & Eric Parrado, 2002. "Dollarization, Monetary Policy, and the Pass-Through," IMF Working Papers 02/188, International Monetary Fund.
  12. Ize, Alain & Yeyati, Eduardo Levy, 2003. "Financial dollarization," Journal of International Economics, Elsevier, vol. 59(2), pages 323-347, March.
  13. 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.
  14. 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.
  15. Martin Schneider & Aaron Tornell, 2000. "Balance SHeet Effects, Bailout Guarantees and Financial Crises," NBER Working Papers 8060, National Bureau of Economic Research, Inc.
  16. Stokey, Nancy L., 1991. "Credible public policy," Journal of Economic Dynamics and Control, Elsevier, vol. 15(4), pages 627-656, October.
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Cited by:
  1. 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.
  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. 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.
  4. 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.
  5. Pelin Berkmen & Eduardo A. Cavallo, 2007. "Exchange Rate Policy and Liability Dollarization," IMF Working Papers 07/33, International Monetary Fund.
  6. 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.
  7. Eduardo Levy Yeyati & Alain Ize, 2005. "Financial De-Dollarization," IMF Working Papers 05/187, International Monetary Fund.
  8. Fiess, Norbert & Shankar, Rashmi, 2005. "Regime-switching in exchange rate policy and balance sheet effects," Policy Research Working Paper Series 3653, The World Bank.
  9. Eduardo Levy Yeyati, 2006. "Exchange Rate Regimes in the 2000s: A Latin American Perspective," Business School Working Papers exchangerate, Universidad Torcuato Di Tella.

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