Dollarization and Financial Integration

Cristina Arellano and Jonathan Heathcote ()

No 6116, CEPR Discussion Papers from C.E.P.R. Discussion Papers

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.

Keywords: dollarization; sovereign debt (search for similar items in EconPapers)
JEL-codes: F33 F34 F36 (search for similar items in EconPapers)
New Economics Papers: this item is included in nep-cba and nep-mon
Date: 2007-02
View list of references

Downloads: (external link)
http://www.cepr.org/pubs/dps/DP6116.asp (application/pdf)
CEPR Discussion Papers are free to download for our researchers, subscribers and members. If you fall into one of these categories but have trouble downloading our papers, please contact us at subscribers@cepr.org

Related works:
Working Paper: Dollarization and financial integration (2007)
Working Paper: Dollarization and Financial Integration (2004)
Working Paper: Dollarization and financial integration (2007)
This item may be available elsewhere in EconPapers: Search for items with the same title.

Export reference: BibTeX RIS (EndNote, ProCite, RefMan) HTML/Text

Persistent link: http://EconPapers.repec.org/RePEc:cpr:ceprdp:6116

Ordering information: This working paper can be ordered from
http://www.cepr.org/pubs/dps/DP6116.asp

Access Statistics for this paper

More papers in CEPR Discussion Papers from C.E.P.R. Discussion Papers
Address: Centre for Economic Policy Research, 53--56 Great Sutton Street, London EC1V 0DG
Series data maintained by ().