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Monetary Policy in Dual Currency Environment

Felices Guillermo () and Vicente Tuesta ()
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Felices Guillermo: Bank of England

No 2007-006, Working Papers from Banco Central de Reserva del Perú

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.

Keywords: Dollarization; Currency Substitution; Policy trade-off; Staggered Price Setting; Open Economy. (search for similar items in EconPapers)
JEL-codes: E50 E52 F00 F30 F41 (search for similar items in EconPapers)
Date: 2007-04
New Economics Papers: this item is included in nep-cba, nep-mac and nep-mon
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Journal Article: Monetary policy in a dual currency environment (2013) Downloads
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