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I have searched arround the web and economic journals trying to find out research related to a macroeconomic model in which the country is fully dollarized, but I haven't had any luck. My main concern is how to deal with exchange rates and the monetary authority. Maybe I just have to forget about them.

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  • $\begingroup$ That is not true. $\endgroup$
    – BB King
    Commented Feb 25, 2016 at 23:25

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You are not likely to find New Keynesian DSGE models where money or currency plays an explicit role. These models mostly abstract from these considerations altogether and monetary policy is simply represented by the interest rate. I understand your situation as I myself have tried to write papers and searched for literature where dollarization plays a role.

If you can, try to circumvent the explicit use of currency in your model. Think about what the currency's role is in your model, e.g. if it is to have different inerest rates in different countries or in different currencies, then simply use different interest rates instead of different currencies.

Another way would be to go outside of the standard DSGE framework and use other international finance, open economy models, as you would find in the Obstfeld/Rogoff book.

If you really want to stick with DSGE, I would recommend looking into open economy DSGE models as well as DSGE models with "Money in the Utility Function".

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A fully dollarized economy (i.e. an economy in which the local currency is dollar) would have an exchange rate which follows the dollar. You have two options.

(a) Model the US economy along with your economy. This would imply that when there are monetary policy changes in the US economy, your model would witness similar monetary policy shocks adjusted for the passthrough from US economy to your economy i.e. how much your economy trades with US.

(b) Think of your economy as one having a near complete pass through since dollar is the reserve currency. Then if your country trades with EU, USD/EU movements will directly affect you.

Monetary policy: your monetary policy can buy and sell government bonds denominated in dollars and still control money supply. So this is the standard case. Additionally, if monetary policy wants to maintain exchange rate stability, then it will buy and sell bonds not only to control nominal interest rate based on inflation, but also based on exchange rates. And the latter is also common for countries where exchange rate fluctuates a lot. They do a lot of forex intervention.

Original Answer: You can use the following paper as a sort of 'benchmark' for exchange rate treatment for a fully dollarized economy.

http://www.nber.org/papers/w22943

In this case, you are not following the Dominant Currency Paradigm completely, but partially. While you will have complete pass-through of the Dollar to home economy, the other currencies can still follow the old method of treatment.

(will update with more references soon!)

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