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Monetary Policy in Dual Currency Environment
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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
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    References listed on IDEAS

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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

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    Cited by:

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    2. 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.
    3. Valida Pantsulaia & Ana Jangveladze & Shalva Mkhatrishvili, 2023. "Negative Externalities of Financial Dollarization," NBG Working Papers 01/2023, National Bank of Georgia.
    4. Daisuke Ikeda, 2020. "Digital Money as a Unit of Account and Monetary Policy in Open Economies," IMES Discussion Paper Series 20-E-15, Institute for Monetary and Economic Studies, Bank of Japan.
    5. Ysusi Carla, 2009. "Analysis of the Dynamics of Mexican Inflation Using Wavelets," Working Papers 2009-09, Banco de México.
    6. srithilat, khaysy & Sun, Gang, 2017. "The Impact of Monetary Policy on Economic Development: Evidence from Lao PDR," MPRA Paper 79369, University Library of Munich, Germany, revised 27 Apr 2017.
    7. Zhao, Hong, 2022. "On the impacts of trend inflation in an open economy," Journal of International Economics, Elsevier, vol. 138(C).
    8. Hossein Tavakolian & Hamed Ghiaie, 2019. "Optimal Inflation Targeting in a Dual-Exchange Rate Oil Economy," THEMA Working Papers 2019-09, THEMA (THéorie Economique, Modélisation et Applications), Université de Cergy-Pontoise.
    9. Ghiaie, Hamed & Tabarraei, Hamid Reza & Tavakolian, Hossein, 2022. "Alternative monetary policy regimes in an oil-exporting economy," The Quarterly Review of Economics and Finance, Elsevier, vol. 83(C), pages 161-177.
    10. Angelo Marsiglia Fasolo, 2014. "The Ramsey Steady State under Optimal Monetary and Fiscal Policy for Small Open Economies," Working Papers Series 357, Central Bank of Brazil, Research Department.
    11. 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.

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    More about this item

    Keywords

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

    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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