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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. Gianluca Cubadda, 2007. "A Unifying Framework for Analysing Common Cyclical Features in Cointegrated Time Series," CEIS Research Paper 102, Tor Vergata University, CEIS.
  2. Cheung, Yin-Wong & Lai, Kon S, 1995. "Lag Order and Critical Values of the Augmented Dickey-Fuller Test," Journal of Business & Economic Statistics, American Statistical Association, vol. 13(3), pages 277-80, July.
  3. Åke Lönnberg & Luis Ignacio Jácome, 2010. "Implementing official Dollarization," IMF Working Papers 10/106, International Monetary Fund.
  4. Fabian Valencia & Luc Laeven, 2008. "Systemic Banking Crises," IMF Working Papers 08/224, International Monetary Fund.
  5. Robert Mundell, 2000. "Currency Areas, Exchange Rate Systems and International Monetary Reform," CEMA Working Papers: Serie Documentos de Trabajo. 167, Universidad del CEMA.
  6. Gourieroux, Christian & Peaucelle, Irina, 1989. "Detecting a long run relationship (with an application to the p.p.p. hypothesis)," CEPREMAP Working Papers (Couverture Orange) 8902, CEPREMAP.
  7. Luis Ignacio Jácome, 2008. "Central Bank Involvement in Banking Crises in Latin America," IMF Working Papers 08/135, International Monetary Fund.
  8. Yin-wong Cheung & Jude Yuen, 2005. "An Output Perspective on a Northeast Asia Currency Union," Working Papers 162005, Hong Kong Institute for Monetary Research.
  9. Pierre-Olivier Gourinchas & Rodrigo Valdes & Oscar Landerretche, 2001. "Lending Booms: Latin America and the World," NBER Working Papers 8249, National Bureau of Economic Research, Inc.
  10. Kaminsky, Graciela L & Reinhart, Carmen M, 1998. "Financial Crises in Asia and Latin America: Then and Now," American Economic Review, American Economic Association, vol. 88(2), pages 444-48, May.
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  12. Mishkin, Frederic S. & Savastano, Miguel A., 2001. "Monetary policy strategies for Latin America," Policy Research Working Paper Series 2685, The World Bank.
  13. Freund, Caroline & Spatafora, Nikola, 2008. "Remittances, transaction costs, and informality," Journal of Development Economics, Elsevier, vol. 86(2), pages 356-366, June.
  14. 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.
  15. 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.
  16. Aaron Tornell & Frank Westermann, 2005. "Boom-Bust Cycles and Financial Liberalization," MIT Press Books, The MIT Press, edition 1, volume 1, number 0262201593, December.
  17. Ahmed, Shaghil, 2003. "Sources of economic fluctuations in Latin America and implications for choice of exchange rate regimes," Journal of Development Economics, Elsevier, vol. 72(1), pages 181-202, October.
  18. Vahid, Farshid & Engle, Robert F., 1997. "Codependent cycles," Journal of Econometrics, Elsevier, vol. 80(2), pages 199-221, October.
  19. 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.
  20. Berger, Helge & Jensen, Henrik & Schjelderup, Guttorm, 2001. "To peg or not to peg?: A simple model of exchange rate regime choice in small economies," Economics Letters, Elsevier, vol. 73(2), pages 161-167, November.
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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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