Endogenous Dollarization, Sovereign Risk Premia and the Taylor Principle

This paper studies the equilibrium determinacy properties of a simple interest rate rule in a small open economy subject to endogenous dollarization (the use of a foreign currency in transactions) and international financial frictions (proxied by a feedback from external debt to sovereign risk premia). It shows that if the domestic and the foreign currency enter as substitute in agents’ preferences the rule’s response to inflation has to be well above one for the equilibrium to be locally unique (reinforced Taylor principle). Sunspot- driven fluctuations appear to be more likely the stronger the feedback from external debt to sovereign risk premia, the larger the elasticity of substitution between currencies and the bigger the extent of network externalities in the use of dollars for transactions. In this context, money growth targeting seems a more robust policy choice, as it guarantees equilibrium determinacy for any parameterization of the economy.