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Monetary Policy in Dual Currency Environment

Listed author(s):
  • 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
Handle: RePEc:rbp:wpaper:2007-006
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  1. Richard Clarida & Jordi Galí & Mark Gertler, 2000. "Monetary Policy Rules and Macroeconomic Stability: Evidence and Some Theory," The Quarterly Journal of Economics, Oxford University Press, vol. 115(1), pages 147-180.
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  4. 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.).
  5. 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.
  6. 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.
  7. Sutherland, Alan, 2002. "A Simple Second-Order Solution Method For Dynamic General Equilibrium Models," CEPR Discussion Papers 3554, C.E.P.R. Discussion Papers.
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  9. 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 370-397, May.
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  12. 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.
  13. Pierpaolo Benigno, 2009. "Price Stability with Imperfect Financial Integration," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 41(s1), pages 121-149, 02.
  14. Stephanie Schmitt-Grohe & Martin Uribe, 2001. "Stabilization policy and the costs of dollarization," Proceedings, Federal Reserve Bank of Cleveland, pages 482-517.
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  16. Paul Castillo & Carlos Montoro & Vicente Tuesta, 2013. "An Estimated Stochastic General Equilibrium Model with Partial Dollarization: A Bayesian Approach," Open Economies Review, Springer, vol. 24(2), pages 217-265, April.
  17. Nicoletta Batini & Joseph Pearlman & Paul Levine, 2006. "Optimal Exchange Rate Stabilization in a Dollarized Economy with Inflation Targets," Computing in Economics and Finance 2006 148, Society for Computational Economics.
  18. V. V Chari & Patrick J. Kehoe & Ellen R. McGrattan, 2002. "Can Sticky Price Models Generate Volatile and Persistent Real Exchange Rates?," Review of Economic Studies, Oxford University Press, vol. 69(3), pages 533-563.
  19. Benigno, Gianluca & Benigno, Pierpaolo, 2006. "Designing targeting rules for international monetary policy cooperation," Journal of Monetary Economics, Elsevier, vol. 53(3), pages 473-506, April.
  20. Laxton, Douglas & Pesenti, Paolo, 2003. "Monetary rules for small, open, emerging economies," Journal of Monetary Economics, Elsevier, vol. 50(5), pages 1109-1146, July.
  21. 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 750-777, October.
  22. Benigno, Gianluca, 2004. "Real exchange rate persistence and monetary policy rules," Journal of Monetary Economics, Elsevier, vol. 51(3), pages 473-502, April.
  23. Calvo, Guillermo A., 1983. "Staggered prices in a utility-maximizing framework," Journal of Monetary Economics, Elsevier, vol. 12(3), pages 383-398, September.
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