Endogenous Financial Dollarization and Exchange Rate Policy

Abstract

We develop a simple model of an economy in which domestic agents borrow and lend from each other in either home or foreign currency. Nominal wage rigidity implies that portfolios are chosen to offset the real variability of labor income. Portfolio choices, in turn, affect the potency of monetary policy, and the mapping from exogenous shocks to aggregate outcomes. The model sheds light on the determinants and implications of financial dollarization, its interaction with monetary policy, and other current issues.

Key Words:

• Financial dollarization
• exchange rates
• monetary policy

JEL Classification:

• F410
• F310

Acknowledgements

We thank the Inter American Development Bank and the National Science Foundation for financial support. We are also indebted to Eduardo Fernandez Arias and Eduardo Levy Yeyati for comments and suggestions. Of course, any shortcomings are ours alone.

Notes

1. It is easily shown that

2. This is justified as in Woodford (2004). One may assume, for instance, that there is an additional equation describing the demand for pesos. Then the central bank would adjust the peso supply to ensure that the desired distribution is obtained.