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Exploring the Implications of Official Dollarization on Macroeconomic Volatility

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  • Roberto Duncan

Abstract

With a few exceptions, the advantages of dollarization have not been discussed in a dynamic general equilibrium framework, especially for partially dollarized economies that are supposed to be good candidates to follow this kind of regime. After reviewing the arguments for and against dollarization, this paper explores its implications on the volatility of the main macroeconomic variables of an emerging small open economy that faces terms-of-trade shocks. Dynamic equilibrium models are used as laboratories to study these issues and contrast two environments: a partially dollarized economy with flexible exchange rate (calibrated for the Peruvian economy) and a fully dollarized economy. Simulation exercises are performed to analyze in both cases the volatility of key variables such as output, consumption, investment, inflation rate, and fiscal deficit. The conclusions are that full dollarization implies (1) higher real volatility, especially on output and investment; (2) lower inflation volatility; (3) higher fiscal deficit volatility; (4) higher output response to terms-of-trade shocks. Consequently, in this context it is difficult to affirm that dollarization reduces country risk. Finally, the paper points up the role of price stickiness and countercyclical monetary policy in these findings.

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Bibliographic Info

Paper provided by Central Bank of Chile in its series Working Papers Central Bank of Chile with number 200.

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Date of creation: Feb 2003
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Handle: RePEc:chb:bcchwp:200

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  1. Pesaran, M. H. & Shin, Y., 1997. "Generalised Impulse Response Analysis in Linear Multivariate Models," Cambridge Working Papers in Economics 9710, Faculty of Economics, University of Cambridge.
  2. Douglas Gale & Xavier Vives, 2002. "Dollarization, Bailouts, And The Stability Of The Banking System," The Quarterly Journal of Economics, MIT Press, vol. 117(2), pages 467-502, May.
  3. Sebastian Edwards, 2001. "Dollarization and Economic Performance: An Empirical Investigation," NBER Working Papers 8274, National Bureau of Economic Research, Inc.
  4. Sebastian Edwards & I. Igal Magendzo, 2001. "Dollarization, Inflation and Growth," NBER Working Papers 8671, National Bureau of Economic Research, Inc.
  5. Enrique G. Mendoza, 2002. "Why Should Emerging Economies Give up National Currencies: A Case for 'Institutions Substitution'," NBER Working Papers 8950, National Bureau of Economic Research, Inc.
  6. Schmitt-Grohe, Stephanie & Uribe, Martin, 2001. "Stabilization Policy and the Costs of Dollarization," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 33(2), pages 482-509, May.
  7. Bufman, G. & Leiderman, L., 1992. "Simulating an Optimizing Model of Currency Substitution," Papers 6-92, Tel Aviv - the Sackler Institute of Economic Studies.
  8. Roberto Chang & Andres Velasco, 2002. "Dollarization: Analytical Issues," NBER Working Papers 8838, National Bureau of Economic Research, Inc.
  9. repec:cto:journl:v:20:y:2000:i:2:p:179-213 is not listed on IDEAS
  10. Reinhart, Carmen & Calvo, Guillermo, 2000. "When Capital Inflows Come to a Sudden Stop: Consequences and Policy Options," MPRA Paper 6982, University Library of Munich, Germany.
  11. Edwards, Sebastian, 2001. "Dollarization: Myths and realities," Journal of Policy Modeling, Elsevier, vol. 23(3), pages 249-265, April.
  12. Michael W. Klein, 2002. "Dollarization and Trade," NBER Working Papers 8879, National Bureau of Economic Research, Inc.
  13. Zeljko Bogetic, 2005. "Official Dollarization: Current Experiences and Issues, Cato Journal, Vol. 20, No. 2 (Fall 2000), 179-213," International Finance 0510006, EconWPA.
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