Academic journal article Journal of Money, Credit & Banking

Optimal Central Bank Areas, Financial Intermediation, and Mexican Dollarization

Academic journal article Journal of Money, Credit & Banking

Optimal Central Bank Areas, Financial Intermediation, and Mexican Dollarization

Article excerpt

WHEN ONE NATION CONSIDERS adopting the money of another nation, discussions naturally focus on money. However, that focus may be misplaced if adopting another country's money leads ultimately to adoption of its central bank and its policies toward financial intermediation. In that case, the most important long-mn effects of adopting the money are likely to operate through channels of financial intermediation and its impact on economic growth.

Should Mexico adopt the U.S. dollar? The answer to that question involves a wide range of issues, ranging from the details of the conversion process and its distributive effects,(1) through standard questions of monetary policy, to significantly broader questions of political spillovers and overall relations between people (and their governments) in the two countries.(2) This paper focuses on an important but neglected issue in the midrange of this spectrum--the economic effects of the range of the central bank's authority. Specifically, what are the likely effects on financial intermediation and economic growth of having a single central bank for two countries rather than separate central banks in each country?

This paper argues that the largest effects on welfare of Mexican dollarization would operate not through the standard "optimal currency area" channels--which involve gains from reducing costs of translating and exchanging currencies, gains from stabilization of business cycles. Nor would they operate through possible welfare improvements from dollarization as a commitment device for monetary policy. Instead, they would result from the effects of dollarization on financial intermediation, investment, and economic growth. In particular, it is useful to separate two components of dollarization (or any other common monetary arrangement, including the Euro). First, dollarization involves a change in the currency used to quote prices, perform accounting, and make transactions; those changes are the common subjects of discussion. The second component, which has been relatively neglected, involves adoption of a common central bank. This has consequences for policies related to bank supervision and regulation, discount window lending, and the lender-of-last-resort function of the central bank. These changes in monetary policy (broadly defined) affect incentives faced by banks and other financial intermediaries, and affect the equilibrium scale of financial intermediation. That, in turn, is likely to affect aggregate investment and long-run economic growth.

This paper does not provide a unified model of an optimal central bank area. The details of such a model would depend critically on issues such as the model of financial intermediation on which it is based, and on assumptions about the political pressures affecting central bank policies, and how adoption of a common central bank would affect those political forces. Instead, this paper discusses the main issues of an optimal central bank area, and presents simple examples based on alternative models of financial intermediation.

1. COMMON CURRENCIES: OPTIMAL CURRENCY AREAS

To appreciate the impact of the issue of central bank areas, it is useful to contrast the issues that typically take precedence in discussions of optimal currency areas and choices of exchange rate systems. The theory of optimal currency areas has emphasized factors such as the relative sizes of domestic money-demand shocks versus foreign monetary shocks and real shocks, the correlations of shocks across countries, and economic flexibility (such as the mobility of labor). When domestic money-demand shocks dominate foreign nominal shocks and nation-specific real shocks (as opposed to common real shocks), that theory implies that a common currency (or a fixed exchange rate system) has an advantage over separate currencies with flexible exchange rates because the

domestic money supply automatically adjusts to changes in domestic to money demand under a common currency (or a true fixed-rate system), without requiring changes in interest rates or the price level that may otherwise result from the money-demand shocks. …

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