Exchange Rate Variability in a Dollarized Small Open Economy
An important feature of transition economies such as the Central and Eastern European countries is the so-called phenomenon of dollarization. It is of particular interest since extensive currency substitution not only makes domestic monetary and fiscal policies less effective, it also makes active exchange rate intervention more dangerous. In this respect, the adoption of new exchange rate regimes is a topic particularly crucial for those countries who wish to join the EU. In this paper we study a small open economy model with frictions, whose main distinctive feature is the introduction of foreign real money balances in a representative agent utility function. The equilibrium for the economy is presented by a highly non-linear multiequational system solved numerically up to a second order approximation. The model is calibrated to Czech Republic for which we could use the evidence on currency substitution collected by the Austrian National Bank. Welfare effects of different exchange rate regimes are taken into account
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