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Dollarization and Financial Integration

  • Jonathan Heathcote
  • Cristina Arellano

This paper builds a simple theoretical model designed to study dollarization. Each period, a benevolent government decides whether or not to dollarize, how much to borrow or lend on an international bond market, and, if dollarization has not occurred, the devaluation rate. In equilibrium, international borrowing is limited endogenously such that the government always chooses to repay when the penalty for default is permanent future exclusion from financial markets. Dollarization implies the loss of the devaluation rate as a policy instrument, but may still be optimal. The reason is that floating defaulters can use the devaluation rate as a substitute for debt in responding to country-specific shocks while dollarized economies in default find themselves in a more uncomfortable situation. Thus dollarization reduces a government's incentives to default, and thereby increases a country's ability to borrow in equilibrium

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Paper provided by Society for Economic Dynamics in its series 2004 Meeting Papers with number 10.

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Date of creation: 2004
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Handle: RePEc:red:sed004:10
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Society for Economic Dynamics Marina Azzimonti Department of Economics Stonybrook University 10 Nicolls Road Stonybrook NY 11790 USA

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