Currency competition and inflation convergence
All agree partial dollarization or currency substitution is a legacy of past inflation and exchange rate instability. Some argue partial dollarization contributes to exchange rate instability. However, if Central Banks respond to dollarization by lowering money growth and maximizing seigniorage revenue, inflation falls and converges on dollar inflation rates. We present a simple model of currency competition with open capital markets to illustrate these points. Empirical tests for Latin America and about twenty other countries suggest that dollarization is both a legacy of past inflation and a constraint on future inflation. Dollarization may complicate monetary policy and prudential regulation, but one silver lining is that currency competition appears to have accelerated the sharp fall in and convergence of Latin inflation rates over the past decade.
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