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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
Date of revision:
Handle: RePEc:fip:fedfwp:2004-30
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  1. Paul Krugman, 1999. "Balance Sheets, the Transfer Problem, and Financial Crises," International Tax and Public Finance, Springer, vol. 6(4), pages 459-472, November.
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  9. Caballero, Ricardo & Krishnamurthy, Arvind, 2005. "Exchange Rate Volatility and the Credit Channel in Emerging Markets: A Vertical Perspective," MPRA Paper 824, University Library of Munich, Germany.
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  13. Alain Ize & Eric Parrado, 2002. "Dollarization, Monetary Policy, and the Pass-Through," IMF Working Papers 02/188, International Monetary Fund.
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