Monetary Policy in a Partially Dollarized Economy: The Case of Peru

This article examines the dynamics of monetary policy in the context of partial dollarization in Peru, specifically by assessing how this incorporation of foreign currency affects the effectiveness of the Central Bank’s policy tools. The phenomenon of dollarization is analyzed as an asset substitution, whereby day-to-day transactions are conducted in the domestic currency, while the dollar is reserved as a store of value, allowing monetary policy to remain effective. Using a vector autoregressive (VAR) model approach based on quarterly data from 1991 to 1999, the study finds that changes in the monetary base—particularly currency in circulation denominated in the domestic currency—significantly explain the variance in inflation. The main findings suggest that, although dollarization affects monetary policy, effective coordination between fiscal and monetary policies has been essential for achieving price stability. This finding highlights the importance of managing multiple monetary policy variables to maintain inflation targets in an environment of highly dollarized conditions. (Abstract and audio: Department of Economic Publications)