Monetary Policy Constraints in a Small Open and Dollarized Economy
Central Banks around the world use monetary and exchange rate policies to affect interest rates aggregate output and internal credit in the short run.[1] Nonetheless, in small open economies these tools have limited efficiency, since global markets determine interest rates. Many small economies use fixed exchange rate policies to control inflation or promote stabilization. This policy puts constraints on the use of monetary tools that increase aggregate output because money supply change is subject to a determined exchange rate. Furthermore, in some small economies people prefer to hold dollars rather than domestic currency to avoid exchange rate risk. This phenomenon, called dollarization, may be beneficial in processes of stabilization and price controls. Nonetheless, dollarization puts further constraints to the use of monetary policy tools. Moreover, this economic context prevents an efficient distribution of credit. When a country is dollarized, its reserves of dollars represent a ceiling of credit. Thus, this phenomenon constraints any attempt to redistribute credit through the generation of money. Consequently, although dollarization prevents inflation and promotes macroeconomic stability, it prevents the Central Bank from coping with external shocks and affect aggregate output. Moreover, it restricts the Central Bank in its task to control the internal credit, which in turn prevents an efficient distribution of credit.
[1] Certainly, this Keynesian view is very arguable and many economists do not support it. Nonetheless, for simplicity we assume certain effectiveness of monetary and exchange rate policies in the short run
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...nsion translates very rapidly into inflation. The costs of dollarization transcend into credit distribution because banks and people demand dollars. Banks assets and liabilities depend on the country dollar reserves, which in turn does not depend on the central bank. Dollarization is a consequence of people loosing faith in monetary institutions. In the short run, dollarization may be beneficial as an anchor for stability and price controls; however, in the case of Bolivia we saw that the costs of dollarization outweigh its benefits after a credible process of stabilization.
Works Cited:
1) Kyn Oldrich, Paper on Joseph Schumpeter.
2) Aggregate Demand in the Short Run, The Mundell-Flemming Model, Chapter 12
3) Bolivian Central Bank annualized Report, Lecturas en Politica Economica, 2002
4) Bolivian Central Bank Economic Data, www.bcb.gov.bo
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Ferguson, S (1999) Keynesian Theory and its implication, College of Management and Economics, Canada University, 298-312
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