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Monetary Policy in Dual Currency Environment

  • Felices Guillermo

    ()

    (Bank of England)

  • Tuesta Vicente

    ()

    (Central Reserve Bank of Peru)

We develop a small open economy general equilibrium model with sticky prices and partial dollarization -a situation where both domestic and foreign currencies coexist. We derive a tractable representation of the model in terms of domestic inflation and the output gap in which a trade-off, which depends on the degree of dollarization, arises endogenously due to the presence of foreign interest rate shocks. We use this framework to show analytically how higher degrees of dollarization induce larger volatilities of the output gap and inflation, thus hampering a central bank’s effectiveness in stabilizing the economy. Our impulse-response functions show that the transmission of such shocks has a positive (negative) effect on inflation and negative (positive) effect on the output gap when money aggregates and consumption are complements (substitutes). We also show that a standard Taylor rule guarantees real determinacy of the rational expectations equilibrium. Finally, we demonstrate that a higher degree of dollarization reduces the determinacy region when the overall money aggregate and consumption are substitutes.

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Paper provided by Banco Central de Reserva del Perú in its series Working Papers with number 2007-006.

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Date of creation: Apr 2007
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Handle: RePEc:rbp:wpaper:2007-006
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  1. Luis Felipe Céspedes & Roberto Chang & Andrés Velasco, 2004. "Balance Sheets and Exchange Rate Policy," American Economic Review, American Economic Association, vol. 94(4), pages 1183-1193, September.
  2. David K. Backus & Gregor W. Smith, 1993. "Consumption and Real Exchange Rates in Dynamic Economies with Non-Traded Goods," Working Papers 1252, Queen's University, Department of Economics.
  3. Calvo, Guillermo A., 1983. "Staggered prices in a utility-maximizing framework," Journal of Monetary Economics, Elsevier, vol. 12(3), pages 383-398, September.
  4. Nicoletta Batini & Paul Levine & Joseph Pearlman, 2008. "Optimal Exchange Rate Stabilization in a Dollarized Economy with Inflation Targets," Working Papers 2008-004, Banco Central de Reserva del Perú.
  5. Jorge Selaive & Vicente Tuesta, 2003. "Net foreign assets and imperfect pass-through: the consumption real exchange rate anomaly," International Finance Discussion Papers 764, Board of Governors of the Federal Reserve System (U.S.).
  6. Stephanie Schmitt-Grohe & Martin Uribe, 2001. "Closing Small Open Economy Models," Departmental Working Papers 200115, Rutgers University, Department of Economics.
  7. Obstfeld, Maurice & Rogoff, Kenneth, 1995. "Exchange Rate Dynamics Redux," CEPR Discussion Papers 1131, C.E.P.R. Discussion Papers.
  8. Luis-Gonzalo Llosa & Vicente Tuesta, 2008. "Determinacy and Learnability of Monetary Policy Rules in Small Open Economies," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 40(5), pages 1033-1063, 08.
  9. Clarida, Richard & Galí, Jordi & Gertler, Mark, 2002. "A Simple Framework for International Monetary Policy Analysis," CEPR Discussion Papers 3355, C.E.P.R. Discussion Papers.
  10. Pierpaolo Benigno, 2008. "Price stability with imperfect financial integration," Proceedings, Board of Governors of the Federal Reserve System (U.S.).
  11. Clarida, Richard & Galí, Jordi & Gertler, Mark, 1998. "Monetary Policy Rules and Macroeconomic Stability: Evidence and Some Theory," CEPR Discussion Papers 1908, C.E.P.R. Discussion Papers.
  12. V.V. Chari & Patrick J. Kehoe & Ellen R. McGrattan, 1998. "Can sticky price models generate volatile and persistent real exchange rates?," Staff Report 223, Federal Reserve Bank of Minneapolis.
  13. Paul Castillo & Carlos Montoro & Vicente Tuesta, 2006. "An Estimated Stochastic General Equilibrium Model with Partial Dollarization: A Bayesian Approach," Working Papers Central Bank of Chile 381, Central Bank of Chile.
  14. Sutherland, Alan, 2002. "A Simple Second-Order Solution Method For Dynamic General Equilibrium Models," CEPR Discussion Papers 3554, C.E.P.R. Discussion Papers.
  15. Cooley, Thomas F & Quadrini, Vincenzo, 2001. "The Cost of Losing Monetary Independence: The Case of Mexico," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 33(2), pages 370-97, May.
  16. Schmitt-Grohe, Stephanie & Uribe, Martin, 2001. "Stabilization Policy and the Costs of Dollarization," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 33(2), pages 482-509, May.
  17. Douglas Laxton & Paolo Pesenti, 2003. "Monetary Rules for Small, Open, Emerging Economies," NBER Working Papers 9568, National Bureau of Economic Research, Inc.
  18. Jordi Gal� & Tommaso Monacelli, 2005. "Monetary Policy and Exchange Rate Volatility in a Small Open Economy," Review of Economic Studies, Oxford University Press, vol. 72(3), pages 707-734.
  19. Maurice Obstfeld & Kenneth S. Rogoff, 1996. "Foundations of International Macroeconomics," MIT Press Books, The MIT Press, edition 1, volume 1, number 0262150476, June.
  20. Benigno, Gianluca & Benigno, Pierpaolo, 2003. "Designing targeting rules for international monetary policy cooperation," Working Paper Series 0279, European Central Bank.
  21. Benigno, Gianluca, 2004. "Real exchange rate persistence and monetary policy rules," Journal of Monetary Economics, Elsevier, vol. 51(3), pages 473-502, April.
  22. Brock, William A, 1974. "Money and Growth: The Case of Long Run Perfect Foresight," International Economic Review, Department of Economics, University of Pennsylvania and Osaka University Institute of Social and Economic Research Association, vol. 15(3), pages 750-77, October.
  23. Richard Clarida & Jordi Gali & Mark Gertler, 2001. "Optimal Monetary Policy in Open versus Closed Economies: An Integrated Approach," American Economic Review, American Economic Association, vol. 91(2), pages 248-252, May.
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