Stabilization Policy and the Costs of Dollarization

This paper compares the welfare costs of business cycles in a dollarized economy to those arising in economies in which monetary policy takes the form of inflation targeting, money growth rate pegs, or devaluation rate rules. The analysis is conducted within an optimizing model of a small open economy with sticky prices. The model is calibrated to the Mexican economy and is driven by three external shocks: terms of trade, world interest rate, and import-price inflation. The welfare comparisons suggest that dollarization is the least successful of the monetary policies considered. Agents are willing to give up between 0.1 and 0.3 percent of their nonstochastic steady-state consumption to see a policy other than dollarization implemented.