Exchange Rate Variability in the Small Open Economy with Currency Substitution

Abstract

An important feature of transition economies such as the Central and Eastern European countries is the so-called phenomenon of dollarization. It is of particular interest since extensive currency substitution not only makes domestic monetary and scal policies less e¤ective, it also makes active exchange rate intervention more dangerous. In this respect, the adoption of new exchange rate regimes is a topic particularly crucial for those countries who wish to join the EU. In this paper we study a small open economy model with frictions, whose main distinctive feature is the introduction of foreign real money balances in a representative agent utility function. The equilibrium for the economy is presented by a highly non-linear multiequational system solved numerically up to a second order approximation. The model is calibrated to Czech Republic for which we could use the evidence on currency substitution collected by the Austrian National Bank. Welfare e¤ects of di¤erent exchange rate regimes are taken into account.