Stabilization Policy and the Costs of Dollarization

This paper compares the welfare costs of business cycles in a dollarized economy to those arising in economies with different monetary arrangements. The alternative monetary policy regimes studied belong to three broad families: devaluation rate rules, inflation targeting, and money growth rate rules. The analysis is conducted within an optimizing model of a small open economy with sticky prices. The model is calibrated to the Mexican economy and is driven by three external shocks: terms of trade, world interest rate, and import-price inflation. We show econometrically that these shocks explain at a minimum 45 percent of the observed forecasting error variance of Mexican output and the Mexican real exchange rate at 8to 16-quarter horizons. The model fits the data relatively well in the sense that it can account for the volatility and comovements of key macroeconomic indicators such as output, consumption, inflation, and the real exchange rate. The welfare comparisons suggest that dollarization is the least successful of the monetary policy rules considered: agents are willing to give up between 0.1 and 0.3 percent of their nonstochastic steady-state consumption to see a policy other than dollarization implemented. JEL Classification Numbers: F41, E58. ∗This paper was prepared for the conference on “Optimal Monetary Institutions for Mexico” sponsored by the Instituto Tecnológico Autónomo de Mexico (ITAM), December 3-4 1999, Mexico City. We would like to thank Elisabeth Huybens, Enrique Mendoza, Marco Del Negro, Carlos Noriega, and seminar participants at the conference on “Optimal Monetary Institutions for Mexico” for very helpful comments. †Phone: 732 932 2960. E-mail: [email protected]. ‡Phone: 215 898 6260. E-mail: [email protected].