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Dollarization as a Signaling Device

The objective of this paper is to point out that dollarization, apart from being a commitment device, may also be used as a signaling device if there is uncertainty about the government’s intentions. To this end, we modify the standard approach to modeling monetary policy by introducing two types of government: good and bad. It is assumed that the good government conducts optimal policy while the bad government prefers to finance higher (than optimal) government expenditure by printing money. People do not observe the type of government, however they know the probability distribution over the two government types. Due to this uncertainty, the good government cannot achieve the first best even if it conducts optimal monetary policy. Hence, the good government has an incentive to dollarize, while the bad governments avoids this step. As a result, we obtain a separating equilibrium where dollarization is a perfect signal of the government type.

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File URL: http://www.nbp.pl/publikacje/materialy_i_studia/63_en.pdf
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Paper provided by National Bank of Poland, Economic Institute in its series National Bank of Poland Working Papers with number 63.

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Length: 25
Date of creation: 2009
Date of revision:
Handle: RePEc:nbp:nbpmis:63
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  1. Stefania Albanesi & V. V. Chari & Lawrence J. Christiano, 2003. "Expectation traps and monetary policy," Staff Report 319, Federal Reserve Bank of Minneapolis.
  2. Lucas, Robert Jr. & Stokey, Nancy L., 1983. "Optimal fiscal and monetary policy in an economy without capital," Journal of Monetary Economics, Elsevier, vol. 12(1), pages 55-93.
  3. Barro, Robert & Alesina, Alberto, 2002. "Currency Unions," Scholarly Articles 4551795, Harvard University Department of Economics.
  4. Christopher Phelan, 2001. "Public trust and government betrayal," Staff Report 283, Federal Reserve Bank of Minneapolis.
  5. Svensson, Lars E O, 1985. "Money and Asset Prices in a Cash-in-Advance Economy," Journal of Political Economy, University of Chicago Press, vol. 93(5), pages 919-44, October.
  6. Silvana Tenreyro & Robert J. Barro, 2002. "Economic effects of currency unions," Working Papers 02-4, Federal Reserve Bank of Boston.
  7. V. V. Chari & Patrick J. Kehoe, 1998. "Optimal fiscal and monetary policy," Staff Report 251, Federal Reserve Bank of Minneapolis.
  8. Enrique G. Mendoza, 2001. "The benefits of dollarization when stabilization policy lacks credibility and financial markets are imperfect," Proceedings, Federal Reserve Bank of Cleveland, pages 440-481.
  9. Arellano, Cristina & Heathcote, Jonathan, 2010. "Dollarization and financial integration," Journal of Economic Theory, Elsevier, vol. 145(3), pages 944-973, May.
  10. Thomas F. Cooley & Vincenzo Quadrini, 2001. "The costs of losing monetary independence: the case of Mexico," Proceedings, Federal Reserve Bank of Cleveland, pages 370-403.
  11. Click, Reid W, 1998. "Seigniorage in a Cross-Section of Countries," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 30(2), pages 154-71, May.
  12. Phelan, Christopher, 2006. "Public trust and government betrayal," Journal of Economic Theory, Elsevier, vol. 130(1), pages 27-43, September.
  13. 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.
  14. Calvo, Guillermo A, 2001. "Capital Markets and the Exchange Rate with Special Reference to the Dollarization Debate in Latin America," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 33(2), pages 312-34, May.
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