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Speculative Attacks on Debts, Dollarization and Optimum Currency Areas

  • Araújo, Aloísio Pessoa de
  • Leon, Márcia Saraiva

The purpose of this article is to contribute to the discussion of the financial aspects of dollarization and optimum currency areas. Based on the model of self-fulfilling debt crisis developed by Cole and Kehoe [4], it is possible to evaluate the comparative welfare of economies, which either keep their local currency and an independent monetary policy, join a monetary union or adopt dollarization. In the two former monetary regimes, governments can issue debt denominated, respectively, in local and common currencies, which is completely purchased by national consumers. Given this ability, governments may decide to impose an inflation tax on these assets and use the revenues so collected to avoid an external debt crises. While the country that issues its own currency takes this decision independently, a country belonging to a monetary union depends on the joint decision of all member countries about the common monetary policy. In this way, an external debt crises may be avoided under the local and common currency regimes, if, respectively, the national and the union central banks have the ability to do monetary policy, represented by the reduction in the real return on the bonds denominated in these currencies. This resource is not available under dollarization. In a dollarized economy, the loss of control over national monetary policy does not allow adjustments for exogenous shocks that asymmetrically affect the client and the anchor countries, but credibility is strengthened. On the other hand, given the ability to inflate the local currency, the central bank may be subject to the political influence of a government not so strongly concerned with fiscal discipline, which reduces the welfare of the economy. In a similar fashion, under a common currency regime, the union central bank may also be under the influence of a group of countries to inflate the common currency, even though they do not face external restrictions. Therefore, the local and common currencies co

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Paper provided by FGV/EPGE Escola Brasileira de Economia e Finanças, Getulio Vargas Foundation (Brazil) in its series Economics Working Papers (Ensaios Economicos da EPGE) with number 446.

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Date of creation: 01 Apr 2002
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Handle: RePEc:fgv:epgewp:446
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  1. Marcel Fratzscher, 2000. "On Currency Crises and Contagion," Working Paper Series WP00-9, Peterson Institute for International Economics.
  2. Felipe Morandé & Klaus Schmidt-Hebbel, 2000. "Chile's Peso: Better than (Just) Living with the Dollar?," Latin American Journal of Economics-formerly Cuadernos de Economía, Instituto de Economía. Pontificia Universidad Católica de Chile., vol. 37(110), pages 177-226.
  3. Alesina, Alberto F & Grilli, Vittorio, 1991. "The European Central Bank: Reshaping Monetary Politics in Europe," CEPR Discussion Papers 563, C.E.P.R. Discussion Papers.
  4. Cole, Harold L. & Kehoe, Timothy J., 1996. "A self-fulfilling model of Mexico's 1994-1995 debt crisis," Journal of International Economics, Elsevier, vol. 41(3-4), pages 309-330, November.
  5. Russell W. Cooper & Hubert Kempf., 2001. "Dollarization and the conquest of hyperinflation in divided societies," Quarterly Review, Federal Reserve Bank of Minneapolis, issue Sum, pages 3-12.
  6. Ilan Goldfajn & Gino Olivares, 2000. "Is adopting Full Dollarization the solution? Looking at the evidence," Textos para discussão 416, Department of Economics PUC-Rio (Brazil).
  7. Rodrigo O. Valdés & Leonardo Hernández, 2001. "What Drives Contagion; Trade Neighborhood, or Financial Links?," IMF Working Papers 01/29, International Monetary Fund.
  8. Páscoa, Mario Rui & Araújo, Aloísio Pessoa de & Torres-Martínez, Juan Pablo, 2001. "Collateral Avoids Ponzi Schemes in Incomplete Markets," Economics Working Papers (Ensaios Economicos da EPGE) 419, FGV/EPGE Escola Brasileira de Economia e Finanças, Getulio Vargas Foundation (Brazil).
  9. Enrique G. Mendoza, 2000. "On the Benefits of Dollarization when Stabilization Policy is not Credible and Financial Markets are Imperfect," NBER Working Papers 7824, National Bureau of Economic Research, Inc.
  10. Steven Radelet & Jeffrey Sachs, 1998. "The Onset of the East Asian Financial Crisis," NBER Working Papers 6680, National Bureau of Economic Research, Inc.
  11. Sargent, Thomas J, 2001. "Comment on Fiscal Consequences for Mexico of Adopting the Dollar," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 33(2), pages 617-25, May.
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