This paper proposes a New Keynesian open economy model with financial frictions in banking side to examine the welfare effects of using macroprudential policies prone to leakages vis-`a-vis monetary policy in dealing with foreign interest rate shocks in a dollarized economy. In the model households¡¯ hedging motive induces them to save in dollars in order to smooth their consumption against adverse foreign interest rate shocks while the banks¡¯ hedging motive is to decrease their dollar deposits as dollar debt burden increases when the economy is in recession induced by a spike in foreign interest rates. Households¡¯ hedging motive to save in dollars incentivizes the banks to issue more dollar deposits as they become abundant relative to domestic currency deposits. The pecuniary externality in the model arises endogenously as the households do not internalize the effect of their hedging motive on currency composition of banks¡¯ liabilities. In order to address this pecuniary externality, I compare the welfare effects of three different policies, imposing a tax on dollar deposits of (i) households, (ii) banks and (iii) augmenting central bank reaction function to smooth exchange rate fluctuations. I find that tax on dollar deposits of households and banks decreases the overall level of dollarization but tax on households decreases welfare due to leakages. Using monetary policy of adjusting interest rates to smooth exchange rate fluctuations is welfare enhancing and reduces the uncertainty arising from foreign interest rate shocks. Lower uncertainty decreases household hedging demand for dollar deposits but increases dollar deposit supply from banking sector which, under plausible calibrations, increases the equilibrium level of dollarization.
Finally, using data from Turkey I test the relative strength of household and bank risk aversion and conclude that banking sector is more risk averse, rejecting the notion that the household hedging motive is the main driver of high levels of dollarization in Turkey.