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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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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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Paper provided by Institute of Empirical Economic Research in its series Working Papers with number 83.

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Length: 32
Date of creation: 05 Aug 2010
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Handle: RePEc:iee:wpaper:wp0083

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Keywords: dollarization; real exchange rate; business cycle comovement; serial correlation; common feature; boom-bust cycles; credit market imperfections; Central America;

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  1. Mishkin, Frederic S. & Savastano, Miguel A., 2001. "Monetary policy strategies for Latin America," Policy Research Working Paper Series 2685, The World Bank.
  2. Freund, Caroline & Spatafora, Nikola, 2008. "Remittances, transaction costs, and informality," Journal of Development Economics, Elsevier, vol. 86(2), pages 356-366, June.
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  4. Gianluca Cubadda, 2007. "A Unifying Framework for Analysing Common Cyclical Features in Cointegrated Time Series," CEIS Research Paper 102, Tor Vergata University, CEIS.
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  7. Aaron Tornell & Frank Westermann, 2005. "Boom-Bust Cycles and Financial Liberalization," MIT Press Books, The MIT Press, edition 1, volume 1, number 0262201593, December.
  8. 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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  14. Fabian Valencia & Luc Laeven, 2008. "Systemic Banking Crises," IMF Working Papers 08/224, International Monetary Fund.
  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. Luis Ignacio Jácome, 2008. "Central Bank Involvement in Banking Crises in Latin America," IMF Working Papers 08/135, International Monetary Fund.
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  18. Åke Lönnberg & Luis Ignacio Jácome, 2010. "Implementing official Dollarization," IMF Working Papers 10/106, International Monetary Fund.
  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.
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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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