Federal Reserve Bank of San Francisco
Working Papers in Applied Economic Theory
Currency boards, dollarized liabilities, and monetary policy credibility
The recent collapse of the Argentine currency board raises new questions about the desirability of formal fixed exchange rate regimes in modern developing economies. This paper examines the impact of dollarized liabilities with potential default for a currency board with costly abandonment. We compare the performance of a currency board to a central bank with full discretion in two environments: One with only idiosyncratic firm shocks, and one with both idiosyncratic shocks and shocks to the dollar-euro rate. We show that the possibility of default with peso-valued exports generates a risk premium on borrowing tied to expected future monetary policy. In addition, the presence of dollarized liabilities mitigates the time-inconsistency problem faced by the monetary authority. Finally, our numerical results demonstrate that the relative performance of the central bank under discretion compared to a currency board is ambiguous with only firm shocks, but that discretion unambiguously dominates when we also introduce shocks to the dollar-euro rate.
Diego Valderrama & Mark M. Spiegel, Currency boards, dollarized liabilities, and monetary policy credibility, Working Papers in Applied Economic Theory 2003-07, Federal Reserve Bank of San Francisco, 2003.
Keywords: Currency boards ; Dollarization ; Foreign exchange rates ; Monetary policy
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