Partial Dollarization: A currency-matching rule and its implications for monetary policy and welfare

This paper contributes to previous studies of partially-dollarized economy inflation targeting by incorporating the effect of a currency-matching rule. Specifically, such a rule implies imposing a restriction to credit dollarization in order to guarantee that any form of foreign-currency-denominated debt (or bank credit) is solely allocated to the export business sector of the eco nomy. The results are straightforward. When the economy is not financially exposed to real exchange rate risk: (i) the volatility of the major macroeconomic variables is reduced, reflecting gains in terms of welfare, and (ii) the optimal policy reaction function becomes less responsive to changes in the risk premium and the foreign interest rate, and more reactive to movements in the output gap and expected inflation. The consequences from (i) and (ii) suggest that the advice that calls for liability de-dollarization in small open economies, should solely apply to the non-export business sector