Optimal Exchange Rate Stabilization in a Dollarized Economy with Inflation Targets

We build a small open-economy model with partial financial dollarization--households hold wealth in domestic currency and a foreign currency; firms also have a balance sheet mismatch as in Gertler, Gilchrist and Natalucci (2001). The degree of dollarization is endogenous to the extent of exchange rate stabilization by the central bank. We identify the optimal monetary policy response and assess the optimal degree of exchange rate stabilization in this set up, drawing policy implications for countries that target inflation in economies of this kind