Dollarization of Liabilities, Net Worth Effects, and Optimal Monetary Policy ∗

Abstract

We consider optimal interest rate policies in an open economy model with balance sheet effects a la Bernanke-Gertler (1989) and overlapping wage contracts a la Calvo (1983). The optimal “flexible inflation targeting” policy under discretion involves a floating exchange rate and partial reaction of home interest rates to external shocks. This policy yields higher welfare than a policy of strictly fixed nominal exchange rates. Other optimal inflation targeting policies under discretion also dominate fixing. These results hold in spite of the credibility advantage of fixing and the presence of dollar liabilities and balance sheet effects. ∗This paper was prepared for the NBER conference on Crisis Prevention, Islamorada, Florida, January 2001. We are grateful to Nouriel Roubini and conference participants for useful comments and discussion, and to Paul Soderlind and Lars Svensson for Gauss programs. Of course, any errors or shortcomings are ours alone.

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