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How strong is the case for dollarization in Central America? An empirical analysis of business cycles, credit market imperfections and the exchange rate

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  • Nannette Lindenberg
  • Frank Westermann

Abstract

In this paper, we contrast two different views in the debate on official dollarization. The Mundell (1961) framework of optimal currency areas and a model on boom-bust cycles, by Schneider and Tornell (2004), who take account of credit market imperfections prevalent in middle income countries. We highlight that the role of the exchange rate is strikingly different in the two models. While in the Mundell framework the exchange rate is expected to smooth the business cycle, the other model predicts that the exchange rate plays an amplifying role. We empirically evaluate both models for eight highly dollarized Central American economies, and find that the main benefit of official dollarization derives from avoiding a mismatch between foreign currency liabilities and domestic revenues, as well as the boom-bust episodes that are likely to follow from it. Using a new method of Cubadda (1999, 2007), we furthermore test for cyclical comovement and reject the hypothesis that the countries form an optimal currency area with the United States according to the Mundell definition.

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Bibliographic Info

Article provided by John Wiley & Sons, Ltd. in its journal International Journal of Finance & Economics.

Volume (Year): 17 (2012)
Issue (Month): 2 (04)
Pages: 147-166

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Handle: RePEc:wly:ijfiec:v:17:y:2012:i:2:p:147-166

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  1. Mishkin, Frederic S. & Savastano, Miguel A., 2001. "Monetary policy strategies for Latin America," Journal of Development Economics, Elsevier, vol. 66(2), pages 415-444, December.
  2. Reinhart, Carmen & Kaminsky, Graciela, 1999. "The twin crises: The causes of banking and balance of payments problems," MPRA Paper 14081, University Library of Munich, Germany.
  3. Robert Mundell, 2000. "Currency Areas, Exchange Rate Systems and International Monetary Reform," CEMA Working Papers: Serie Documentos de Trabajo. 167, Universidad del CEMA.
  4. Helge Berger & Henrik Jensen & Guttorm Schjelderup, 2001. "To Peg or Not To Peg? A Simple Model of Exchange Rate Regime Choice In Small Economies," CESifo Working Paper Series 468, CESifo Group Munich.
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  7. Edgar L. Feige & Vedran Šošiæ & Michael Faulend & Velimir Šonje, 2002. "Unofficial Dollarization in Latin America: Currency Substitution, Network Externalities and Irreversibility," International Finance 0205002, EconWPA.
  8. Cubadda, Gianluca, 1999. "Common Cycles in Seasonal Non-stationary Time Series," Journal of Applied Econometrics, John Wiley & Sons, Ltd., vol. 14(3), pages 273-91, May-June.
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  12. Reinhart, Carmen & Kaminsky, Graciela, 1998. "Financial crises in Asia and Latin America: Then and now," MPRA Paper 13877, University Library of Munich, Germany.
  13. Aaron Tornell & Frank Westermann, 2005. "Boom-Bust Cycles and Financial Liberalization," MIT Press Books, The MIT Press, edition 1, volume 1, number 0262201593.
  14. Vahid, Farshid & Engle, Robert F., 1997. "Codependent cycles," Journal of Econometrics, Elsevier, vol. 80(2), pages 199-221, October.
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  16. Luis Ignacio Jácome, 2008. "Central Bank Involvement in Banking Crises in Latin America," IMF Working Papers 08/135, International Monetary Fund.
  17. Urga, Giovanni, 2007. "Common Features in Economics and Finance: An Overview of Recent Developments," Journal of Business & Economic Statistics, American Statistical Association, vol. 25, pages 2-11, January.
  18. Åke Lönnberg & Luis Ignacio Jácome, 2010. "Implementing Official Dollarization," IMF Working Papers 10/106, International Monetary Fund.
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  20. Fabian Valencia & Luc Laeven, 2008. "Systemic Banking Crises: A New Database," IMF Working Papers 08/224, International Monetary Fund.
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Cited by:
  1. Tim Willems, 2011. "Using Dollarized Countries to Analyze the Effects of US Monetary Policy Shocks," 2011 Meeting Papers 200, Society for Economic Dynamics.

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