Ebook: On the Reasons Behind Fear of Floating: Pass-through Effects vs. Contractionary Depreciations

Based on a simple open economy framework, this analysis rationalizes the existence of “fear of floating”-
type responses and uncovers some important implications about to role of pass-through effects and
contractionary depreciations. By examining how the optimal monetary response varies when altering the
effects of the real exchange rate on output and inflation, this analysis reveals the existence of nonlinearities when we allow for contractionary depreciations. In particular, an increase in the pass-through
coefficient may well imply the need to tighten or relax the monetary stance depending on how
contractionary real depreciations are. These findings may help to understand the empirical results where
pass-through effects have failed to appear significant when accounting for low exchange rate and high
interest rate variability. They also reveal the complications that arise when conducting monetary policy in
a partially dollarized economy.
Key words: Fear of floating, central bank preferences, dollarization, pass-through,
contractionary depreciations