Dollarization: An Irreversible Decision

Roger Craine.

No E01-298, Economics Working Papers from University of California at Berkeley

Abstract: After faithfully maintaining a fixed exchange rate and fully convertible currency for almost a decade Argentina still pays higher interest rates on peso denominated debt than on US dollar denominated debt. The interest rate spread is the price of keeping the option to devalue alive. Argentina has sufficient foreign reserves to defend the currency against any attack, but they could choose to devalue if the pain of maintaining the currency peg got too great. Investors fear devaluation and they charge Argentina for the option to devalue. In 1999 President Menem recommended "dollarizing" the economy. Dollarization extinguishes the option to devalue. If dollarization is a credible commitment to maintain a fixed exchange rate, then it is an irreversible decision. This is the first paper, as far as I know, to explicitly model the unique feature -- irreversibility -- of a dollarization policy. In addition, it is the first paper to recognize that if a dollarization is a potential exchange rate regime choice, then the equilibrium is a mixed strategy equilibrium. Argentina might dollarize. I compute Nash equilibria and the transition probabilities that a country will move from a currency board regime to dollarizing, or floating, in one year, or two years, out to seven years. I model shocks to the exchange rate as a jump-diffusion process. The jumps represent large "asymmetric" shocks to the exchange rate -- such as Brazil's 1999 devaluation. The probability of dollarization is inversely related to the jump probability. When the jump probability is small, the probability of dollarization is large and the probability of floating is small. When the jump probability is large, the probability of floating is large and the probability of dollarization is small.

Date: 2001-03-01
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