On Inflation Targeting and Foreign Exchange Interventions in a Dual Currency Economy

Abstract

In this paper we study monetary policy response to foreign and domestic shocks in a small open inflation-targeting economy facing a high level of euroization. We try to identify how the level of euroization affects the central bank’s decisions on the key policy rate when two situations are compared: when the key policy rate is the only instrument the central bank has at its disposal, and the situation when the central bank can use interventions in the foreign exchange market as an additional monetary policy instrument. Our results suggest that a high level of euroization makes central banks more restrictive in the case of an adverse foreign interest rate shock, as well as less expansionary in the case of an adverse shock in aggregate demand. The introduction of sterilized interventions in the foreign exchange market as an additional central bank’s instrument, under certain assumptions, tends to alleviate the response of the key policy rate to both domestic and international shocks. This model also suggests that euroized economies tend to sell more foreign exchange reserves in the case of both negative external and domestic aggregate demand shocks compared to countries with lower level of euroization.