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Monetary policy and the currency denomination of debt: a tale of two equilibria

  • Roberto Chang
  • Andres Velasco

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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  1. V. V. Chari & Patrick J Kehoe, 1998. "Sustainable Plans," Levine's Working Paper Archive 600, David K. Levine.
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  9. Corsetti, Giancarlo & Pesenti, Paolo, 2002. "Self-Validating Optimum Currency Areas," CEPR Discussion Papers 3220, C.E.P.R. Discussion Papers.
  10. 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.
  11. Jeanne, Olivier, 2003. "Why Do Emerging Economies Borrow in Foreign Currency?," CEPR Discussion Papers 4030, C.E.P.R. Discussion Papers.
  12. Reinhart, Carmen & Calvo, Guillermo, 2002. "Fear of floating," MPRA Paper 14000, University Library of Munich, Germany.
  13. Ize, Alain & Yeyati, Eduardo Levy, 2003. "Financial dollarization," Journal of International Economics, Elsevier, vol. 59(2), pages 323-347, March.
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  15. Stokey, Nancy L., 1991. "Credible public policy," Journal of Economic Dynamics and Control, Elsevier, vol. 15(4), pages 627-656, October.
  16. Ricardo Hausmann & Michael Gavin & Carmen Pagés-Serra & Ernesto H. Stein, 1999. "Financial Turmoil and the Choice of Exchange Rate Regime," IDB Publications (Working Papers) 4128, Inter-American Development Bank.
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