Dominant Currency Paradigm: Financial Dollarization View

This paper proposes an alternative view for the dominant currency paradigm. More specifically, the role of financial dollarization in exchange rate pass-through is analyzed. In highly dollarized countries, where domestic producers are unhedged, exchange rate depreciations against a dominant currency create additional pressures on inflation. In particular, depreciation increases unhedged borrowers’ debt-service costs, which then push overall prices up. We use a panel of countries with highly dollarized economies to empirically estimate the impact of dominant currency exchange rates on inflation. On the theoretical front, we demonstrate this channel by a simple dynamic stochastic general equilibrium (DSGE) model to show how liability dollarization of domestic producers may change the optimal monetary policy reaction to USD exchange rate movements globally. These results provide an interesting insight for monetary policymakers, especially for countries with small open economies that are exposed to external shocks. The implications can help gauge the optimal monetary policy response to the US monetary policy-induced exchange rate movements for countries that may even not trade much with the US but have high financial dollarization.