Monetary dynamics under dollarization: explaining Ecuador’s puzzle

Emilio Ocampo and Nicolás Cachanosky

No 898, CEMA Working Papers: Serie Documentos de Trabajo. from Universidad del CEMA

Abstract: This paper investigates a puzzle in the behavior of the money supply in Ecuador after it formally adopted the US dollar as its currency in January 2000. Modern open economy macroeconom-ics (MOEM) predicts that in a small open economy under an official dollarization regime, the money supply is endogenous to movements in the balance of payments. However, Ecuador’s monetary and balance of payment statistics suggest otherwise. This incongruity has led some authors to claim that MOEM does not hold in Ecuador. We challenge this claim and argue that three factors can explain the apparent puzzle: a) monetary data misspecification, b) measure-ment errors in foreign trade flows, and c) an exogenous expansion of its balance sheet of the Central Bank of Ecuador’s (CBE) during the period 2009-2014 to finance government deficits. We conclude that Ecuador’s experience under dollarization is consistent with a key prediction of MOEM: inflation convergence. However, it also shows that the constraints that in theory an official dollarization places on fiscal profligacy and monetary activism can be overcome by creative spendthrift politicians. Finally, we highlight the challenge of measuring cash in econo-mies that are dollarized or are part of a currency union and the need to consider the institutional and regulatory framework adopted for the central bank after dollarization to understand the monetary dynamics of an officially dollarized economy.

Keywords: money supply; dollarization (search for similar items in EconPapers)
JEL-codes: E42 E59 O54 (search for similar items in EconPapers)
Pages: 30 pages
Date: 2025-06
New Economics Papers: this item is included in nep-mon and nep-pay
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Persistent link: https://EconPapers.repec.org/RePEc:cem:doctra:898

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