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Dollarization and financial integration

Author

Listed:
  • Cristina Arellano
  • Jonathan Heathcote

Abstract

How does a country's choice of exchange rate regime impact its ability to borrow from abroad? We build a small open economy model in which the government can potentially respond to shocks via domestic monetary policy and by international borrowing. We assume that debt repayment must be incentive compatible when the default punishment is equivalent to permanent exclusion from debt markets. We compare a floating regime to full dollarization. ; We find that dollarization is potentially beneficial, even though it means the loss of the monetary instrument, precisely because this loss can strengthen incentives to maintain access to debt markets. Given stronger repayment incentives, more borrowing can be supported, and thus dollarization can increase international financial integration. This prediction of theory is consistent with the experiences of El Salvador and Ecuador, which recently dollarized, as well as with that of highly-indebted countries like Italy which adopted the Euro as part of Economic and Monetary Union: in each case, around the time of regime change, spreads on foreign currency government debt declined substantially.

Suggested Citation

  • Cristina Arellano & Jonathan Heathcote, . "Dollarization and financial integration," Staff Report, Federal Reserve Bank of Minneapolis.
    • Handle: RePEc:fip:fedmsr:385
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    References listed on IDEAS

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    Cited by:

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    3. Roc Armenter & Martin Bodenstein, 2005. "Does the time inconsistency problem make flexible exchange rates look worse than you think?," Staff Reports 230, Federal Reserve Bank of New York.
    4. Michael Kumhof, 2004. "Fiscal Crisis Resolution: Taxation versus Inflation," Working Papers 102004, Hong Kong Institute for Monetary Research.
    5. Sergey Narkevich & Pavel Trunin, 2012. "Reserve Currencies: Factors of Evolution and their Role in the World Economy," Research Paper Series, Gaidar Institute for Economic Policy, issue 162P.

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