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Financial Dollarization in Latin America

  • Robert Rennhack
  • Masahiro Nozaki
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    This paper tests several explanations for financial dollarization (FD), with an emphasis on Latin America. The results provide evidence that FD is a rational response to inflation uncertainty. The paper builds on previous research by finding that an exchange rate policy biased towards currency depreciation and currency mismatches tends to contribute to high FD and that FD is highly persistent. These results suggest that countries with significant FD should encourage the use of domestic currency by maintaining macroeconomic stability; allowing more exchange rate flexibility and less bias towards currency depreciation; and adapting prudential regulations to ensure that costs associated with FD are fully internalized in financial contracts. At the same time, restoring confidence in the domestic currency may take many years of sound policies.

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    File URL: http://www.imf.org/external/pubs/cat/longres.aspx?sk=18732
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    Paper provided by International Monetary Fund in its series IMF Working Papers with number 06/7.

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    Length: 36
    Date of creation: 01 Jan 2006
    Date of revision:
    Handle: RePEc:imf:imfwpa:06/7
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    1. de la Torre, Augusto & Schmukler & Sergio L., 2004. "Coping with risk through mismatches : domestic and international financial contracts for emerging economies," Policy Research Working Paper Series 3212, The World Bank.
    2. De Nicolo, Gianni & Honohan, Patrick & Ize, Alain, 2003. "Dollarization of the banking system : good or bad?," Policy Research Working Paper Series 3116, The World Bank.
    3. Carmen M. Reinhart & Kenneth S. Rogoff & Miguel A. Savastano, 2003. "Addicted to Dollars," CEMA Working Papers 594, China Economics and Management Academy, Central University of Finance and Economics.
    4. Uribe, Martin, 1997. "Hysteresis in a simple model of currency substitution," Journal of Monetary Economics, Elsevier, vol. 40(1), pages 185-202, September.
    5. Morris Goldstein & Philip Turner, 2004. "Controlling Currency Mismatches in Emerging Markets," Peterson Institute Press: All Books, Peterson Institute for International Economics, number 373, May.
    6. Guillermo A. Calvo & Carmen M. Reinhart, 2002. "Fear Of Floating," The Quarterly Journal of Economics, MIT Press, vol. 117(2), pages 379-408, May.
    7. R Blundell & Steven Bond, . "Initial conditions and moment restrictions in dynamic panel data model," Economics Papers W14&104., Economics Group, Nuffield College, University of Oxford.
    8. Alain Ize, 2005. "Financial Dollarization Equilibria; A Framework for Policy Analysis," IMF Working Papers 05/186, International Monetary Fund.
    9. Pablo Emilio Guidotti & Carlos A. Rodriguez, 1991. "Dollarization in Latin America; Gresham's Law in Reverse?," IMF Working Papers 91/117, International Monetary Fund.
    10. Adam Bennett & Eduardo Borensztein & Tomás J. T. Baliño, 1999. "Monetary Policy in Dollarized Economies," IMF Occasional Papers 171, International Monetary Fund.
    11. Windmeijer, Frank, 2005. "A finite sample correction for the variance of linear efficient two-step GMM estimators," Journal of Econometrics, Elsevier, vol. 126(1), pages 25-51, May.
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