Monetary Policy Constraints in an Small Open and Dollarized Economy

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Monetary Policy Constraints in a Small Open and Dollarized Economy Central Banks around the world use monetary and exchange rate policies to affect interest rates aggregate output and internal credit in the short run.[1] Nonetheless, in small open economies these tools have limited efficiency, since global markets determine interest rates. Many small economies use fixed exchange rate policies to control inflation or promote stabilization. This policy puts constraints on the use of monetary tools that increase aggregate output because money supply change is subject to a determined exchange rate. Furthermore, in some small economies people prefer to hold dollars rather than domestic currency to avoid exchange rate risk. This…show more content…
The government applied orthodox policies to stop inflation and adjust the budget. These policies achieved positive results on price stabilization; however, unemployment and GDP growth were hindered. One of the main outcomes of this crisis was the dollarization of bank accounts, which gave more confidence to the public. The real demand for bolivianos declined, since people preferred to hold dollars. Nonetheless people were still doing transaction in bolivianos, which generates inflationary pressures under monetary expansion. Moreover, Bolivia carries a crawling peg exchange rate, which restricts the effectiveness of monetary policy tools because the central bank must peg the boliviano to the dollar. To analyze the Bolivian economic context, we need to formalize and fit the effects of dollarization into a macroeconomic model. The most appropriate model for the Bolivian economic context is The Mundell-Fleming model, since Bolivia is a small and one of the most open economies in the region[1]. [1] Currently Bolivia has the lowest tariffs in the region and has no restriction on the flows of capital Under the Mundell-Flemming model, Bolivia would have a vertical LM curve because the interest rate is constant and exogenously given. Under the Mundell Flemming model, when the central bank uses monetary policy, it shift the vertical LM curve to the right, which lowers the exchange rate, increases net exports and aggregate

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