Academic journal article Journal of Money, Credit & Banking

Dollarization Traps

Academic journal article Journal of Money, Credit & Banking

Dollarization Traps

Article excerpt

Unofficial "dollarization" has become a pervasive phenomenon in many emerging market economies. Discussions of the dollarization phenomenon have often focused either on official dollarization, where a government abandons the domestic currency and replaces it with a "hard" foreign currency (such as the U.S. dollar), or on unofficial currency substitution, i.e. the competition between U.S. dollars and the domestic currency as a medium of exchange. In this paper, we focus on unofficial dollarization in the sense of asset substitution, where a foreign currency competes with local assets, especially domestic capital, as a store of value. The paper assesses the impact of dollarization on capital accumulation, a topic that has been neglected in the dollarization literature.

It is well understood and documented that economies become dollarized during episodes of high inflation. However, disinflations are not necessarily followed by dedollarization. In particular, Argentina, Bolivia, Peru, Romania, Russia, Ukraine, and other countries have remained highly dollarized long after the inflation rate was brought down to single digits.

This paper presents a new explanation of the dollarization hysteresis paradox. We relate it to the underdevelopment of the financial system or a financial intermediation failure that happens during a period of high inflation. The link between financial underdevelopment and dollarization has been noted in several descriptive papers, but it has never been modeled explicitly. In our model high inflation undermines financial intermediation, leading to the adoption of a less efficient production technology, which in turn makes a dollarization trap possible. Two technologies and a fixed cost of operating the more efficient technology are key to generating a dollarization trap in our model. In this trap arbitrage equates the return on productive capital and dollars. Hence the exogenously given return on dollars pins down the return on productive capital, thus making the capital stock and output independent of inflation. A disinflation increases holdings of dollars rather than the capital stock. Rising dollarization despite falling inflation is a counterintuitive result which is nevertheless consistent with empirical evidence of several Latin American and transition economies. (1) The only way to exit from such a trap is to reduce inflation below a threshold level.

The rest of the paper is organized as follows. The next section discusses related literature. Section 2 describes the model. Section 3 discusses production technologies. Section 4 discusses steady-state equilibria and transitional dynamics. Section 5 considers the effects of inflation and disinflation on the equilibrium. Section 6 offers concluding remarks. All proofs are relegated to the Appendix.

1. RELATED LITERATURE

As noted above, discussions of the dollarization phenomenon have focused in the first instance on official dollarization, where a government abandons the domestic currency and replaces it with a "hard" foreign currency (such as the U.S. dollar). (2) In the second instance, discussions of dollarization have focused on unofficial currency substitution, i.e. competition between U.S. dollars and the domestic currency as a medium of exchange. The literature on currency substitution has been concerned with issues of real money demand, optimal money growth, the inflation tax, and real exchange rate movements in the context of endowment, infinitely lived representative agent models. Different authors adopt different money demand specifications. (3) Vegh (1995) and Sturzenegger (1997) are the only ones who explicitly model the production side of the economy. However, in their models labor is the only input, and so there is no substitution between productive capital and dollars.

We focus on unofficial dollarization in the sense of asset substitution, where a foreign currency competes with local assets, especially domestic capital, as a store of value. …

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