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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

Author

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  • Nannette Lindenberg
  • Frank Westermann

Abstract

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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Suggested Citation

  • Nannette Lindenberg & Frank Westermann, 2012. "How strong is the case for dollarization in Central America? An empirical analysis of business cycles, credit market imperfections and the exchange rate," International Journal of Finance & Economics, John Wiley & Sons, Ltd., vol. 17(2), pages 147-166, April.
    • Handle: RePEc:wly:ijfiec:v:17:y:2012:i:2:p:147-166
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    Cited by:

    1. Emilio Ocampo, 2023. "Dollarization as an Effective Commitment Device: The Case of Argentina," CEMA Working Papers: Serie Documentos de Trabajo. 848, Universidad del CEMA.
    2. Willems, Tim, 2013. "Analyzing the effects of US monetary policy shocks in dollarized countries," European Economic Review, Elsevier, vol. 61(C), pages 101-115.
    3. Hem Basnet & Subhash Sharma, 2015. "Exchange rate movements and policy coordination in Latin America," Journal of Economics and Finance, Springer;Academy of Economics and Finance, vol. 39(4), pages 679-696, October.
    4. María de Lourdes RODRÍGUEZ-ESPINOSA & Ramón A. CASTILLO-PONCE, 2017. "Synchronization of Economic Activity between Dollarized Economies and the United States. The cases of Ecuador and El Salvador," Applied Econometrics and International Development, Euro-American Association of Economic Development, vol. 17(1), pages 89-100.
    5. Tim Willems, 2010. "What are the Effects of Monetary Policy Shocks? Evidence from Dollarized Countries," Tinbergen Institute Discussion Papers 10-099/2, Tinbergen Institute, revised 25 Mar 2013.
    6. Tim Willems, 2011. "Using Dollarized Countries to Analyze the Effects of US Monetary Policy Shocks," 2011 Meeting Papers 200, Society for Economic Dynamics.

    More about this item

    JEL classification:

    • E32 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles - - - Business Fluctuations; Cycles
    • E52 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Monetary Policy
    • F36 - International Economics - - International Finance - - - Financial Aspects of Economic Integration
    • O54 - Economic Development, Innovation, Technological Change, and Growth - - Economywide Country Studies - - - Latin America; Caribbean

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