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Monetary Policy in Dual Currency Environment

Author

Listed:
  • Felices Guillermo

    () (Bank of England)

  • Tuesta Vicente

    () (Central Reserve Bank of Peru)

Abstract

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.

Suggested Citation

  • Felices Guillermo & Tuesta Vicente, 2007. "Monetary Policy in Dual Currency Environment," Working Papers 2007-006, Banco Central de Reserva del Perú.
  • Handle: RePEc:rbp:wpaper:2007-006
    as

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    File URL: http://www.bcrp.gob.pe/docs/Publicaciones/Documentos-de-Trabajo/2007/Working-Paper-06-2007.pdf
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    References listed on IDEAS

    as
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    3. Jordi Galí & 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.
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    Blog mentions

    As found by EconAcademics.org, the blog aggregator for Economics research:
    1. Política Monetária e Demanda por Moeda Estrangeira
      by Angelo M. Fasolo in The Duke of Hazard on 2009-11-01 01:59:00

    Citations

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    Cited by:

    1. Carla Ysusi, 2009. "Analysis of the Dynamics of Mexican Inflation Using Wavelets," Working Papers 2009-09, Banco de México.
    2. Javier García-Cicco, 2008. "Recent Developments in Monetary Policy Analysis for Emerging Countries," Ensayos Económicos, Central Bank of Argentina, Economic Research Department, vol. 1(51), pages 123-142, April - S.
    3. Paul Castillo & Carlos Montoro & Vicente Tuesta, 2006. "Measuring the Natural Interest Rate for the Peruvian Economy," Working Papers 2006-003, Banco Central de Reserva del Perú.
    4. Airaudo, Marco, 2012. "Endogenous Dollarization, Sovereign Risk Premia and the Taylor Principle," School of Economics Working Paper Series 2012-11, LeBow College of Business, Drexel University.

    More about this item

    Keywords

    Dollarization; Currency Substitution; Policy trade-off; Staggered Price Setting; Open Economy.;

    JEL classification:

    • E50 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - General
    • E52 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Monetary Policy
    • F00 - International Economics - - General - - - General
    • F30 - International Economics - - International Finance - - - General
    • F41 - International Economics - - Macroeconomic Aspects of International Trade and Finance - - - Open Economy Macroeconomics

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