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Assessing the Impact of Real Shocks on Small Dollarized Economies

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  • René Cabral-Torres

Abstract

This paper compares the impact of real shocks on small open economies operating under two opposite corner solutions: flexible exchange rates and official dollarization. Using an asymmetric two-country model of policy coordination, we show that although a pegged regime like dollarization is an effective device to achieve price stability, small open economies might be better off under a flexible exchange rate regime than under dollarization following any symmetric or asymmetric real shock. We also consider the claim that many small economies have only a limited ability to use their own monetary policy effectively and contrast the dollarization regime with one in which a small open economy follows "fear of floating" practices. In this case, we observe that unless its size is trivial, maintaining monetary policy sovereignty--even if it is not fully exploited--allows the domestic economy to experience lower losses from stabilization in the face of symmetric shocks. Only when an economy is negligibly small, are the costs of stabilization following "fear of floating" practices the same as those under dollarization.

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Paper provided by Department of Economics, University of York in its series Discussion Papers with number 05/27.

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Handle: RePEc:yor:yorken:05/27

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Keywords: Credibility problems; dollarization; fear of floating; real shocks;

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  1. Martin, Philippe, 1995. "Free-riding, convergence and two-speed monetary unification in Europe," European Economic Review, Elsevier, vol. 39(7), pages 1345-1364, August.
  2. Alberto Alesina & Robert J. Barro, 2001. "Dollarization," American Economic Review, American Economic Association, vol. 91(2), pages 381-385, May.
  3. Reinhart, Carmen & Calvo, Guillermo, 2002. "Fear of floating," MPRA Paper 14000, University Library of Munich, Germany.
  4. Martin, Philippe, 1997. "The Exchange Rate Policy of the Euro: A Matter of Size?," CEPR Discussion Papers 1646, C.E.P.R. Discussion Papers.
  5. Frederic S Mishkin & Miguel A Savastano, 2002. "Monetary Policy Strategies For Emerging Market Countries: Lessons From Latin America," Comparative Economic Studies, Palgrave Macmillan, vol. 44(2-3), pages 45-82, September.
  6. Guillermo A. Calvo, 2002. "On dollarization," The Economics of Transition, The European Bank for Reconstruction and Development, vol. 10(2), pages 393-403, July.
  7. Dennis W. Jansen & Ming-Jang Weng, 1999. "A K% Money Growth Leadership Rule In An International Monetary Policy Game," Contemporary Economic Policy, Western Economic Association International, vol. 17(4), pages 506-516, October.
  8. Ghironi, Fabio & Giavazzi, Francesco, 1998. "Currency areas, international monetary regimes, and the employment-inflation tradeoff," Journal of International Economics, Elsevier, vol. 45(2), pages 259-296, August.
  9. Eichengreen, Barry, 2001. "What problems can dollarization solve?," Journal of Policy Modeling, Elsevier, vol. 23(3), pages 267-277, April.
  10. Matthew B. Canzoneri & Dale W. Henderson, 1991. "Monetary Policy in Interdependent Economies: A Game-Theoretic Approach," MIT Press Books, The MIT Press, edition 1, volume 1, number 0262031787, December.
  11. Sebastian Edwards & I. Igal Magendzo, 2001. "Dollarization, Inflation and Growth," NBER Working Papers 8671, National Bureau of Economic Research, Inc.
  12. Roberto Chang, 2000. "Dollarization: a scorecard," Economic Review, Federal Reserve Bank of Atlanta, issue Q3, pages 1-12.
  13. Canzoneri, Matthew B & Gray, Jo Anna, 1985. "Monetary Policy Games and the Consequences of Non-cooperative Behavior," International Economic Review, Department of Economics, University of Pennsylvania and Osaka University Institute of Social and Economic Research Association, vol. 26(3), pages 547-64, October.
  14. Barry Eichengreen & Fabio Ghironi, 2002. "Transatlantic Trade-Offs in the Age of Balanced Budgets and European Monetary Union," Open Economies Review, Springer, vol. 13(4), pages 381-411, October.
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