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Dollarization and financial integration

Cristina Arellano and Jonathan Heathcote ()

No 385, Staff Report from Federal Reserve Bank of Minneapolis

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: Financial crises; Foreign exchange administration (search for similar items in EconPapers)
New Economics Papers: this item is included in nep-cba, nep-ifn and nep-mon
Date: 2007
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Related works:
Journal Article: Dollarization and financial integration (2010) Downloads
Working Paper: Dollarization and Financial Integration (2007) Downloads
Working Paper: Dollarization and financial integration (2007) Downloads
Working Paper: Dollarization and Financial Integration (2004)
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