Monetary Policy in a Small Open Economy with Endogenous Financial Dollarization∗

This paper analyses optimal monetary policy in a small open economy allowing for financial dollarization (FD). More importantly, we endogenise FD, making it dependent on the expected monetary policy. Contrary to the standard small open economy model, where central banks should control domestic (producer) prices and adopt a pure floating exchange rate regime, we find that some exchange rate control is optimal. The extent of this control increases with the level of domestic credit and the degree of openness, and decreases with the degree of rigidity in wages. We also show that introducing regulations preventing agents from making deposits and loans in foreign currency increases welfare but is not Pareto improving given that lenders are worse-off. JEL Classification: E-52, F-41, F-36, G-11