Monetary Policy and the Currency Denomination of Debt: A Tale of Two Equilibria

27 Pages Posted: 25 Oct 2004 Last revised: 3 Aug 2010

See all articles by Andrés Velasco

Andrés Velasco

Harvard University - Harvard Kennedy School (HKS); National Bureau of Economic Research (NBER)

Roberto Chang

Rutgers University, New Brunswick/Piscataway - Faculty of Arts and Sciences-New Brunswick/Piscataway - Department of Economics; National Bureau of Economic Research (NBER)

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Date Written: October 2004

Abstract

Exchange rate policies depend on portfolio choices, and portfolio choices depend on anticipated exchange rate policies. This opens the door to multiple equilibria in policy regimes. We construct a model in which agents optimally choose to denominate their assets and liabilities either in domestic or in foreign currency. The monetary authority optimally chooses to float or to fix the currency, after portfolios have been chosen. We identify conditions under which both fixing and floating are equilibrium policies: if agents expect fixing and arrange their portfolios accordingly, the monetary authority validates that expectation; the same happens if agents initially expect floating. We also show that a flexible exchange rate Pareto-dominates a fixed one. It follows that social welfare would rise if the monetary authority could precommit to floating.

Suggested Citation

Velasco, Andrés and Chang, Roberto, Monetary Policy and the Currency Denomination of Debt: A Tale of Two Equilibria (October 2004). NBER Working Paper No. w10827, Available at SSRN: https://ssrn.com/abstract=603647

Andrés Velasco (Contact Author)

Harvard University - Harvard Kennedy School (HKS) ( email )

79 John F. Kennedy Street
Cambridge, MA 02138
United States

National Bureau of Economic Research (NBER)

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Roberto Chang

Rutgers University, New Brunswick/Piscataway - Faculty of Arts and Sciences-New Brunswick/Piscataway - Department of Economics ( email )

75 Hamilton Street
New Brunswick, NJ 08901
United States

National Bureau of Economic Research (NBER)

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

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