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Dollarization and financial integration

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  • Cristina Arellano
  • Jonathan Heathcote

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, spreads on foreign currency government debt declined substantially around the time of regime change.

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Bibliographic Info

Paper provided by Board of Governors of the Federal Reserve System (U.S.) in its series International Finance Discussion Papers with number 890.

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Date of creation: 2007
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Handle: RePEc:fip:fedgif:890

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Keywords: Dollarization;

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Citations

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Cited by:
  1. Adam, Klaus & Grill, Michael, 2012. "Optimal Sovereign Default," CEPR Discussion Papers 9178, C.E.P.R. Discussion Papers.
  2. Eduardo Borensztein & Ugo Panizza, 2009. "The Costs of Sovereign Default," IMF Staff Papers, Palgrave Macmillan, vol. 56(4), pages 683-741, November.
  3. 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.
  4. 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.).
  5. Michael Kumhof, 2004. "Fiscal Crisis Resolution: Taxation Versus Inflation," 2004 Meeting Papers 874, Society for Economic Dynamics.
  6. 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.
  7. Roc Armenter & Martin Bodenstein, 2006. "Does the time inconsistency problem make flexible exchange rates look worse than you think?," International Finance Discussion Papers 865, Board of Governors of the Federal Reserve System (U.S.).
  8. Krzysztof Makarski, 2009. "Dollarization as a Signaling Device," National Bank of Poland Working Papers 63, National Bank of Poland, Economic Institute.
  9. Asonuma, Tamon, 2014. "Sovereign defaults, external debt and real exchange rate dynamics," MPRA Paper 55133, University Library of Munich, Germany.
  10. Betty C. Daniel & Christos Shiamptanis, 2010. "Sovereign Default Risk in a Monetary Union," Working Papers 2010-3, Central Bank of Cyprus.

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