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

  • Andres Velasco
  • Roberto Chang

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
Note: IFM
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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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