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Dollarization and Financial Integration

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  • Jonathan Heathcote
  • Cristina Arellano

Abstract

This paper builds a simple theoretical model designed to study dollarization. Each period, a benevolent government decides whether or not to dollarize, how much to borrow or lend on an international bond market, and, if dollarization has not occurred, the devaluation rate. In equilibrium, international borrowing is limited endogenously such that the government always chooses to repay when the penalty for default is permanent future exclusion from financial markets. Dollarization implies the loss of the devaluation rate as a policy instrument, but may still be optimal. The reason is that floating defaulters can use the devaluation rate as a substitute for debt in responding to country-specific shocks while dollarized economies in default find themselves in a more uncomfortable situation. Thus dollarization reduces a government's incentives to default, and thereby increases a country's ability to borrow in equilibrium

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Bibliographic Info

Paper provided by Society for Economic Dynamics in its series 2004 Meeting Papers with number 10.

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Date of creation: 2004
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Handle: RePEc:red:sed004:10

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Postal: Society for Economic Dynamics Christian Zimmermann Economic Research Federal Reserve Bank of St. Louis PO Box 442 St. Louis MO 63166-0442 USA
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Web page: http://www.EconomicDynamics.org/society.htm
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Keywords: Dollarization; International Debt; Default;

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References

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Citations

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Cited by:
  1. Krzysztof Makarski, 2009. "Dollarization as a Signaling Device," National Bank of Poland Working Papers 63, National Bank of Poland, Economic Institute.
  2. 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.).
  3. Michael Kumhof, 2004. "Fiscal Crisis Resolution: Taxation versus Inflation," Working Papers 102004, Hong Kong Institute for Monetary Research.
  4. Eduardo Borensztein & Ugo Panizza, 2009. "The Costs of Sovereign Default," IMF Staff Papers, Palgrave Macmillan, vol. 56(4), pages 683-741, November.
  5. Adam, Klaus & Grill, Michael, 2012. "Optimal Sovereign Default," Working Papers 12-16, University of Mannheim, Department of Economics.
  6. Betty C. Daniel & Christos Shiamptanis, 2010. "Sovereign Default Risk in a Monetary Union," Working Papers 2010-3, Central Bank of Cyprus.
  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. 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.
  9. Asonuma, Tamon, 2014. "Sovereign defaults, external debt and real exchange rate dynamics," MPRA Paper 55133, University Library of Munich, Germany.
  10. 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.

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