Exchange Rate and Inflation Dynamics in Dollarized Economies

In this paper we build a model of a dollarized economy with imperfect financial markets to analyze and qualify the common view that countries with higher dollarization exhibit higher pass-through. We show that the classic inflationary effects of a real depreciation -higher internal demand and imported inflation- can be offset or diminished in a dollarized economy by higher financial costs and a balance-sheet effect. Thus, pass-through coefficients could be smaller or even negative in economies with a high degree of dollarization. We test the implications of the model using a panel of a hundred-plus countries with differing degrees of dollarization. The results confirm that pass-through coefficients are higher in more dollarized economies, but they also show that large depreciations tend to generate a negative impact on the pass-through coefficient, this impact being higher the higher the level of dollarization of the economy. Additionally, the exchange rate regime is shown to matter, in that countries with fixed exchange rates suffer larger balance-sheet effects of depreciations.