Is Dollarization Good?

ABSTRACT

This paper discusses major analytical aspects of dollarization and their practical implications. We develop a simple model to stress that dollarization implies the loss of independent monetary policy, yet the significance of such losses can only be evaluated in conjunction with assumptions about the policymaking process. If the government is benevolent and has no credibility problems, dollarization causes a fall in welfare, which can be measured. However, outcomes are rather different if credibility is absent and dollarization can serve as a commitment device: the welfare impact of dollarization is ambiguous. We also evaluate other implications of dollarization, such as those related to last resort lending and financial stability.

1 Introduction

In the dollarization debate, some have indeed argued that dollars would provide for a”better” currency than existing national currencies while others have argued exactly the opposite. We prefer to be agnostic here. Given the absence of better micro-foundations, it is probably best to impose an assumption that does not bias the desirability of dollarization in one way or another. Fixing the exchange rate involves a welfare loss relative to the Ramsey policy. So, in the absence of commitment, expected welfare under fixed exchange rates may or may not improve. There is a tradeoff between credibility and flexibility, and the better choice depends on model parameters.

2 Dollarization and the Lender of Last Resort - 3 -

The recent crises in emerging markets have underscored a crucial question: what is the role of exchange rate policy in the generation and/or prevention of those crises? Arguably, it is this issue that has provided the main impetus for dollarization proposals in developing countries. And, paradoxically, consideration of the same question has led to calls for the exact opposite, flexible exchange rates.

The debate has been influenced by some prominent aspects of observed

crises. In them, the financial system, and particularly domestic banks, played a key role. Exchange rate pegs often collapsed as the central bank was attempting to bail out the domestic financial system in the midst of a panic. The panic was possible, in turn, because the countries that went in...

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...although surely not exhaustive, discussion of the theoretical issues associated with dollarization. Our analysis has been organized around a simple, single framework, which can be extended in many directions. We emphasize that the study of a single framework is useful for at least two reasons.

It gives an idea of how the different aspects of the dollarization debate are related to each other. We have borrowed from previous literature, and we have also provided new observations, against dollarization. For this we emphasized that there is no presumption that dollarization should reduce interest rates.

Perhaps most importantly, we have identified some arguments that are

lacking satisfactory theoretical foundations. Given the interest on dollarization,

these arguments remain fertile ground for future research.

REFERENCES

www.levy.org/docs/wrkpap/papers/337.html

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www.smealsearch.psu.edu/1994.html

www.econpapers.hhs.se/paper/chbbcchwp/175.htm

www.home.uleth.ca/~geoffrey.hale/3270_deandollar.html

www.stern.nyu.edu/globalmacro/ exchange_rates/dollarization.html

www.cato.org/pubs/fpbriefs/fpb-052es.html

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