Escaping the Financial Dollarization Trap: The Role of Foreign Exchange Intervention

Paul Castillo, Ruy Lama and Juan Medina

No 2024/127, IMF Working Papers from International Monetary Fund

Abstract: Financial dollarization is considered a source of macroeconomic instability in many emerging economies. Dollarization constrains the ability of central banks to stimulate output during economic downturns. In contrast to the conventional monetary transmission mechanism, a monetary policy loosening in a dollarized economy leads to a currency depreciation, adverse balance sheet effects, and a contraction in investment and output growth. In this paper we evaluate the role of foreign exchange reserves in facilitating macroeconomic stabilization in a financially dollarized economy. We first show empirically that foreign exchange intervention in response to capital outflows can largely reduce the volatility of output and the real exchange rate in dollarized economies. We then develop a small open economy model with foreign currency debt and balance sheets effects. Our quantitative model shows that an active foreign exchange intervention policy is sufficient for offsetting the output volatility associated with financial dollarization. These results can explain the prevalence of low macroeconomic volatility in some dollarized economies (Christiano et al., 2021) and they highlight the role of foreign exchange reserves in reducing the welfare costs of dollarization.

Keywords: Foreign Exchange Intervention; Global Financial Cycle; Financial Dollarization; Balance Sheet Effects; Emerging Economies.; dollarization trap; dollarized economy; FX intervention; liability dollarization; intervention policy; Dollarization; Capital outflows; Capital flows; International reserves; Global (search for similar items in EconPapers)
Pages: 39
Date: 2024-06-21
New Economics Papers: this item is included in nep-acc, nep-cba, nep-dge, nep-fdg, nep-mon and nep-opm
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