Dollar Liquidity, Money and Credit in a Small Open Dollarized Economy

This paper analyzes the liquidity questions relating to financial dollarization. We formalize monetary mechanisms under dollarization, shedding light on the interconnection of the balance of payments with money and credit aggregates in a small open dollarized economy. After presenting the dollar money creation mechanism under financial dollarization, we propose a new measure of dollar liquidity in dollarized economies defined as the Gross Foreign Assets of the Locational Banks Sector, equal to the sum of the central bank’s gross international reserves and the gross liquid foreign assets of the locational banks sector. Our empirical results for Lebanon suggest that our measure of dollar liquidity has a significant and positive contemporaneous connection with total banks deposits and a lagged connection with total banks credit to the private sector in the period extending from 2002Q1 to 2017Q2. We test our results for robustness during the ongoing financial and monetary crisis period in Lebanon, that is a dollar liquidity crisis. We also test our results using data from two other major dollarized economies: Peru and Russia.