Liability Dollarization and Fear of Floating

This paper addresses the question of whether fear of floating in developing countries can be justified as optimal discretionary monetary policy in a dollarized economy where intermediate goods importers face Bernanke-type credit constraint. Exchange rate depreciation not only worsens the net-worth but also increases the financing amount of importer firms who borrow in foreign currency, hence exaggerating the borrowing finance premium. Besides, because of high exchange rate passthrough, fluctuations in the exchange rate also have strong impacts on domestic price levels and production. These effects, together, magnify the macroeconomic consequences of the economy that experiences external and domestic technology shocks. It can be shown that the fixed exchange rate regime dominates the inflation targeting regime in both the role of cushioning shocks and in welfare terms.