Monetary policy in a dollarized economy where balance sheets matter

Does the dollarization of liabilites and the resulting balance sheet vulnerability prevent monetary policy from serving its conventional countercyclical role? We study this question in a model of a small open economy in which domestic firms face an imperfect capital market, with risk premia depending on net worth as in Bernanke and Gertler [Am. Econ. Rev. 79 (1989) 14.]. In spite of the financial fragility channels present in the model, the conventional wisdom still holds: under a floating exchange rate, countercyclical monetary policy does help cushion the impact of foreign real shocks. (C) 2001 Elsevier Science B.V. All rights reserved.