Dollarization Hysteresis and Network Externalities: The Case of Russia

Nienke Oomes () and Andrei Shinkevich

No 5B.4, CeNDEF Workshop Papers, January 2001 from Universiteit van Amsterdam, Center for Nonlinear Dynamics in Economics and Finance

Abstract: ''Dollarization'' can be defined as the fraction of a country's total currency that is held in the form of U.S. dollars. Based on this definition, the Russian economy seems dollarized to a large extent. Anecdotal evidence indicates that dollar bills are widely used, not just as a store of wealth but also for transactions purposes, even though the latter is illegal. The ratio of dollars to total currency in Russia quickly increased from almost zero in January 1992 to over 70% today. According to some estimates, Russia now has the second largest volume of U.S. dollars circulating in cash, after the United States itself. Existing models of currency substitution predicti that the dollarization ratio in a country should increase with exchange rate depreciation or the interest rate differential. However, the experience with dollarization in many Latin American countries has shown that, while dollarization often does increase with such variables, reductions in these variables typically do not induce de-dollarization, or at least have a much smaller, asymmetric effect. This phenomenon has been referred to as ''dollarization hysteresis''. The main hypothesis of this paper is that dollarization hysteresis exists in Russia as well, and that it is caused by network externalities in the demand for money. Network externalities arise from the fact that the demand for a given currency depends on the currency in which one is paid, as well as on the extent to which this currency is accepted by others as a means of payment. In the theoretical part of the paper, we show that network externalities can indeed be a cause of dollarization hysteresis. In the empirical part of the paper, we then test whether dollarization hysteresis in fact exists in Russia, i.e. whether the rate of exchange rate depreciation and the interest rate differential have asymmetric effects on the dollarization ratio.

Date: 2001-01-04
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