An Estimated Stochastic General Equilibrium Model with Partial Dollarization: A Bayesian Approach

Abstract

This paper develops and estimates a dynamic stochastic general equilibrium New Keynesian model of a small open economy with partial dollarization. We use Bayesian techniques and Peruvian data to evaluate two forms of dollarization: currency substitution (CS) and price dollarization (PD). Our empirical results are as follows. First, we find that the two forms of partial dollarization are important to explain the Peruvian data. Second, models with both forms of dollarization dominate models without dollarization. Third, a counter-factual exercise shows that by eliminating both forms of partial dollarization the response of both output and consumption to a monetary policy shock doubles, making the interest rate channel of monetary policy more effective. Forth, based on the variance decomposition of the preferred model (with CS and PD), we find that demand type shocks explain almost all the fluctuation in CPI inflation, being the monetary shock the most important (39 percent). Remarkably, foreign disturbances account for 34 percent of output fluctuations.