Dollarization hysteresis, inflation jumps, and fear of inflation

We analyze dollarization hysteresis in emerging economies, linking the persistent demand for foreign currency to past inflation experiences and the perceived risk of returning to high inflation episodes. Using data from 116 emerging economies, we show that dollarization remains high even after disinflation, particularly in countries with histories of extreme inflation. We uncover three stylized facts: (i) high inflation episodes are frequent and severe; (ii) they coincide with sharp currency depreciations, triggering shifts to dollar deposits; and (iii) dollarization persists long after inflation stabilizes. Motivated by these facts, we develop a portfolio-choice model where agents allocate between domestic and dollar deposits. We show that although a hedge demand—associated with the observed correlation between inflation and depreciation in low-inflation economies—plays a role, it is not sufficient to generate a positive allocation to dollar deposits. By incorporating inflation disasters and fear of inflation—persistent pessimism shaped by past instability—we account for dollarization's resilience. Together, risk hedging, disaster risk, and belief heterogeneity explain why dollarization persists in low-inflation emerging economies.