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Endogenous Dollarization, Sovereign Risk Premia and the Taylor Principle

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  • Airaudo, Marco

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    (Department of Economics & International Business LeBow College of Business Drexel University)

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    Abstract

    This paper studies the equilibrium determinacy properties of a simple interest rate rule in a small open economy subject to endogenous dollarization (the use of a foreign currency in transactions) and international financial frictions (proxied by a feedback from external debt to sovereign risk premia). It shows that if the domestic and the foreign currency enter as substitute in agents’ preferences the rule’s response to inflation has to be well above one for the equilibrium to be locally unique (reinforced Taylor principle). Sunspot- driven fluctuations appear to be more likely the stronger the feedback from external debt to sovereign risk premia, the larger the elasticity of substitution between currencies and the bigger the extent of network externalities in the use of dollars for transactions. In this context, money growth targeting seems a more robust policy choice, as it guarantees equilibrium determinacy for any parameterization of the economy.

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    File URL: http://dl.dropboxusercontent.com/u/162210677/RePEc/drx/wpaper/LeBow%20College%20of%20Business%20Working%20Paper%202012-11.pdf
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    Bibliographic Info

    Paper provided by LeBow College of Business, Drexel University in its series School of Economics Working Paper Series with number 2012-11.

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    Length: 33 pages
    Date of creation: 15 Jun 2012
    Date of revision:
    Handle: RePEc:ris:drxlwp:2012_011

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    Web page: http://www.lebow.drexel.edu/
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    Related research

    Keywords: Interest Rate Rules; Taylor Rules; Multiple Equilibria; Currency Substitution; Dollarization;

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