Currency substitution,risk premia and the Taylor principle |
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| Institution: | 1. HEC Montréal, Canada;2. Sauder School of Business, University of British Columbia, Canada;3. School of Business Administration, American University of Sharjah, United Arab Emirates;1. Department of Economics and Quantitative Methods, Westminster Business School, University of Westminster, London NW1 5LS, UK;2. Department of Economics and IME, University of Salamanca, Salamanca, Spain;1. Department of Finance, National Central University, Taiwan;2. Booth School of Business, University of Chicago, USA;1. Department of Electrical Engineering, Amirkabir University of Technology, Tehran, Iran;2. Department of Electrical Engineering, Sharif University of Technology, Tehran, Iran |
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| Abstract: | This paper studies the equilibrium determinacy properties of a simple interest rate rule in a small open economy subject to currency substitution (i.e., the use of a foreign currency for domestic transactions) and risk premia on foreign borrowing. It shows that if currencies are substitute in the provision of liquidity services the rule׳s response to inflation has to be sufficiently above unity for the equilibrium to be locally determinate. This reinforced Taylor principle requirement appears to be more binding in economies characterized by a larger elasticity of currency substitution, more debt-elastic country risk premia, and intermediate degrees of dollarization in transactions. |
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| Keywords: | Small open economy Interest rate rules Taylor principle Determinacy Currency substitution Dollarization |
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