Optimal exchange rate stabilization in a dollarized economy with an inflation target

In this paper, we construct a model of a small, open economy with households that are partially dollarized in terms of their wealth holdings in domestic and foreign currencies, as in Felices and Tuesta (2006). In this model, the degree of dollarization is endogenous to the degree of exchange rate stabilization by the Central Bank. In this context, we have identified the optimal monetary policy response under both a rule-based and a discretionary framework, and we calculate the optimal degree of exchange rate stabilization. These results have policy implications for economies with partial dollarization and inflation targets. The model’s results suggest three policy lessons. First, although partial dollarization complicates the conduct of monetary policy, the introduction of an inflation target can reduce the costs of price stability. Second, in a partially dollarized economy, there are welfare gains from including the exchange rate in the monetary policy rule. Third, exchange rate smoothing reduces the possibility of multiple equilibria under dollarization. (Audio: Department of Economic Publications)