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Real Dollarization, Financial Dollarization, and Monetary Policy

Alain Ize () and Eric Parrado ()

Working Papers Central Bank of Chile from Central Bank of Chile

Abstract: This paper explores the interaction of real dollarization (dollar indexing of wages), financial dollarization (dollar denomination of financial contracts) and monetary policy in a general equilibrium model with real shocks. Real dollarization is avoided as long as the home monetary authorities perform optimally (i.e., they maximize local welfare). Instead, dollarization increases when central banks perform poorly, and even more so when the correlation between domestic and external shocks is high, since in this case the (presumably optimal) foreign monetary policy guarantees a better level of protection against macroeconomic uncertainty. While real dollarization contributes to financial dollarization, important asymmetries between the two arise.

Date: 2006-10
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