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Dollarization and Financial Integration

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  • Arellano, Cristina
  • Heathcote, Jonathan

Abstract

How does a country’s choice of exchange rate regime impact its ability to borrow from abroad? We build a small open economy model in which the government can potentially respond to shocks via domestic monetary policy and by international borrowing. We assume that debt repayment must be incentive compatible when the default punishment is equivalent to permanent exclusion from debt markets. We compare a floating regime to full dollarization. We find that dollarization is potentially beneficial, even though it means the loss of the monetary instrument, precisely because this loss can strengthen incentives to maintain access to debt markets. Given stronger repayment incentives, more borrowing can be supported, and thus dollarization can increase international financial integration. This prediction of theory is consistent with the experiences of El Salvador and Ecuador, which recently dollarized, as well as with that of highly-indebted countries like Italy which adopted the Euro as part of Economic and Monetary Union: in each case, around the time of regime change, spreads on foreign currency government debt declined substantially.

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Paper provided by C.E.P.R. Discussion Papers in its series CEPR Discussion Papers with number 6116.

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Date of creation: Feb 2007
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Handle: RePEc:cpr:ceprdp:6116

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Keywords: dollarization; sovereign debt;

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References

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Citations

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Cited by:
  1. Eduardo Borensztein & Ugo Panizza, 2009. "The Costs of Sovereign Default," IMF Staff Papers, Palgrave Macmillan, vol. 56(4), pages 683-741, November.
  2. Asonuma, Tamon, 2014. "Sovereign defaults, external debt and real exchange rate dynamics," MPRA Paper 55133, University Library of Munich, Germany.
  3. Michael Kumhof, 2004. "Fiscal Crisis Resolution: Taxation versus Inflation," Working Papers 102004, Hong Kong Institute for Monetary Research.
  4. Schmitz, Birgit & von Hagen, Jürgen, 2011. "Current account imbalances and financial integration in the euro area," Journal of International Money and Finance, Elsevier, vol. 30(8), pages 1676-1695.
  5. Adam, Klaus & Grill, Michael, 2012. "Optimal Sovereign Default," CEPR Discussion Papers 9178, C.E.P.R. Discussion Papers.
  6. Krzysztof Makarski, 2009. "Dollarization as a Signaling Device," National Bank of Poland Working Papers 63, National Bank of Poland, Economic Institute.
  7. Samir Jahjah & Bin Wei & Vivian Zhanwei Yue, 2012. "Exchange rate policy and sovereign bond spreads in developing countries," International Finance Discussion Papers 1049, Board of Governors of the Federal Reserve System (U.S.).
  8. Betty C. Daniel & Christos Shiamptanis, 2010. "Sovereign Default Risk in a Monetary Union," Working Papers 2010-3, Central Bank of Cyprus.
  9. Slavov, Slavi T., 2009. "Do common currencies facilitate the net flow of capital among countries?," The North American Journal of Economics and Finance, Elsevier, vol. 20(2), pages 124-144, August.
  10. Roc Armenter & Martin Bodenstein, 2005. "Does the time inconsistency problem make flexible exchange rates look worse than you think?," Staff Reports 230, Federal Reserve Bank of New York.

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